History tells us that when the FED starts to raise interest rates, sooner or later the economy will be hit.
Today, we’ll discuss what’s going on with rates and the economy, and where we are in the current economic cycle in order to determine portfolio risk exposures.
The Relationship Between Interest Rates & The Economy
If we take a look at the chart below representing the effective federal funds rate, we can see that usually but not always, a tightening period is followed by a recession depicted by the grey columns.
The tightening from 2004 to 2006 when the FED’s rate went from 1% to 5% very quickly resulted in the 2009 recession. The same happened in the late 1990s and late 1980s, but didn’t happen in the early 1990s.
What’s also important to note is that the FED had already stopped increasing rates in 2006, but the real doom and gloom scenario didn’t materialize until 2008. So, this isn’t a perfect metric and you will never find perfect metrics in economics because the economy is just an aggregation of millions or even billions of individuals whose behavior can’t be predicted.
The point is that higher interest rates impact what we do and the financial decisions we make. Mortgage rates have increased 50% in the last 2 years which means that buying a house is now much more expensive.
Another factor to consider is that house prices have also increased 10% in the last two years and almost 50% in the last 5 years. Something that definitely doesn’t help home buyers.
My point is that sooner or later, buyers will stop being so enthusiastic about homes, cars and other purchases which will slowdown the economy. Now, don’t get me wrong, remember that we are always talking about economics which isn’t perfectly predictable. Home prices, demand, and the economy will continue to grow until it all reaches an inflection point when there will be an inevitable recession because you can’t have people buy three cars or three homes. Well, you can, but let’s hope people are smarter than they were just 10 years ago.
Digging deeper into the housing market, Wall Street is usually very good at predicting these long term trends as there’s usually good visibility into the future of trends like home purchases. If we take a look at a stock like Toll Brothers (NYSE: TOL), which is the largest luxury home builder in the U.S., we can see that the market was very positive in the last two years as the economy was doing well but since January, the sentiment has turned.
Further, novice investors may find it difficult to understand why a company like TOL would start declining when it has seen its revenue quadruple since 2011, increase 15% in the last fiscal year and had earnings expand 50%, has a price to earnings ratio of 11.5, and a forward price to earnings ratio of 9.5 when the average market’s valuation is 24. Additionally, TOL’s book value doubled in the last 5 years, going from $15 to $30 per share.
The key to investing is future risk reward and not what has happened in the past. TOL also missed some expectations in the last two quarters which sent the share price down. The problem is that in the late part of the economic cycle, you can’t really grow that quickly anymore as you can’t find available contractors, lumber prices go up, and sooner or later, the higher interest rates will put pressure on buyers.
But the key to keep in mind is what happens when a recession comes, unemployment increases, and demand for luxury homes suddenly evaporates. TOL’s asset side of the balance sheet is more than 80% inventory and we know what happens if demand for housing falls. Against the $7.7 billion in inventories and $8.8 billion in current assets, there is $5.1 billion in debt that, unlike the value of TOL’s inventory, doesn’t decline if there’s a recession but increases as TOL’s interest payments go up.
Housing and especially construction companies are extremely cyclical. We aren’t even close to a recession and higher interest rates are already impacting TOL’s stock making it seem extremely cheap. The problem is that the first weaknesses can be seen exactly in the housing market as it starts to slow down which later leads to a spiral and a recession. A look at TOL’s stock price in the past will show what I mean.
TOL’s stock price peaked in 1987 at above $3 only to decline to $0.5 in 1990 during the recession. There were other 3 30% to 50% ups and down up to 2005 when the stock capitulated from the 2005 peak. As the FED told the world it would start tightening, the stock again dropped significantly in 2016.
The conclusion is that stocks like TOL are the first to fall when things look like they will go south and when the odds of a recession increase. This is what explains the low PE ratio and great fundamentals.