Where to Invest, When Interest Rates are so Low

Unlike most people who analyze investments, I think there are periods of time where domestic long-only investors may be consigned to low or even negative returns.  As investors, we are generally optimists; we don’t like can’t win situations like the Kobayashi Maru.

When money market funds offer near-zero yields, asset allocation becomes complicated.  Near the beginning of such a period, it might pay to take a lot of risk when credit spreads are wide.  But when they are more narrow, but wide by historic standards, the question is tough.

I start analyses like this the way I do the the piece Risks, not Risk.  I look at the individual risks and ask whether they are overpriced or underpriced.  Here is my current assessment:

  • Equities — slightly undervalued at present, particularly high quality stocks.  (US and foreign)
  • Credit — Investment grade credit and high yield are fairly valued at present.
  • Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
  • Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
  • Inflation — Low, but future inflation is probably underestimated.
  • Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.

All that said, for retail investors, I am not crazy about the options at present.  I would leave more in money market funds than most would as a part of capital preservation.  I would also invest in high quality dividend-paying stocks, because they are undervalued relative to BBB corporates.

Beyond that, I would consider fixed income investments in the Canadian and Australian Dollars.  I am skittish about the US Dollar, Euro, Pound, Yen and Swiss Franc.  (The least of those worries is the US Dollar itself.)

We live in a world where risk is often not fairly rewarded at present, due to the liquidity trap that the major central banks have enter into.  My view here is to play it safe when conditions are not crazy bad, and take a lot of risk whe credit markets are in the tank.

As for now, I would hold high quality US stocks that pay dividends, US money market funds, and Canadian and Australian short term bond funds.  Commodities and companies that produce them should play a small role as well.

  • Equities — somewhat overvalued at present.  (US and foreign)
  • Credit — Investment grade credit is slightly overvalued, and high yield is overvalued.
  • Real Estate — the future stream of mortgage payments that need to be made is high relative to the present value of properties.  There will be more defaults, both in commercial and residential.
  • Yield Curve — Steep.  It is reasonable to lend long, so long as inflation does not take off.
  • Inflation — Low, but future inflation is probably underestimated.
  • Foreign currency — One of my rules of thumb is that when there is not much compensation offered for risk in the US, it is time to look abroad, particularly at foreign fixed income.
  • Commodities — the global economy is not running that hot now.  There will be pressures on resources in the future, but that seems to be a way off.
  • Volatility is underpriced — most have assumed a simple V-shaped rebound but there are a lot of problems left to solve.


  • Kolya says:

    Hi David,

    Could you suggest a good mutual fund to cheaply get exposure for “high quality US stocks that pay dividends”. I was thinking of the Vanguard Dividend Growth Fund. Thanks

  • maynardGkeynes says:

    Vanguard Dividend Growth Fund is too closely correlated with the S&P 500 for my taste. (Look at the charts.) Actually, and here’s the problem, except for cash, EVERYTHING is too closely correlated to the S&P 500 nowadays. Basically, and I think that this is David’s point, for people playing with their own money, this market is un-investable. Money markets, FDIC banks, maybe some more TIPS for me right now. I’m not going to fight the FED, but I’m not going to play their little game either.

  • Terry says:

    As a retiree focused on cap preservation & income generation, in addition to high-quality, high-dividend stocks and money market/CU savings accounts, I have found quality municipal bonds in my state (VA) have produced good returns–gains & yield–so far. I have sold those with substantial gains (as rates went down) and either socked the money away in MMA equivalents or re-invested in high-quality munis selling below par value (& why some are so priced I don’t understand).

    I will say that VA’s conservative state & municipal financial requirements (some constitutional dating to the 18th century) seem to make it among the safer places for municipal bond investments; it’s certainly not like California.

    I appreciate the inflation risk in this strategy and am willing to shift when I see signs of that happening, but I don’t expect that will happen for awhile.

  • Nate says:


    Maybe look into something like the S&P Dividend Aristocrats: http://www.standardandpoors.com/indices/sp-500-dividend-aristocrats/en/us/?indexId=spusa-500dusdff–p-us—-

    It’s a list of companies that have raised their dividends for the last 25 years.

  • maynardGkeynes says:

    @Terry, a problem with munis is the big spreads when you buy or sell. If you use a broker, he’s probably hiding this from you. This makes the strategy of shifting in and out when conditions change costly. Basically, these are illiquid investments. (Remember the ARS debacle?) When rates go up, as I think they will have to, munis are going to get killed from every possible angle. FWIW, I don’t share your faith in the great Commonwealth of Virginia. It’s a low tax electorate, and if push comes to shove, Richmond will default on their bonds rather than raise taxes on rednecks to pay “all them highfalutin retirees.”

  • Bob_in_MA says:

    By most valuations, stocks seem to be over-valued.

    CAPE (10-year P/E) is about 20, in the highest 20% of its historical range:

    The Q ratio for nonfinancial corporations (market price/net asset value) is very close to where it was in October 2007. That’s because assets of businesses have fallen along with equities.

    Dividend yields are a complete joke.

    What valuation method are you using for equities?

  • Mike C says:

    Very good and useful post. Nice to get your thoughts on some actionable investment ideas at the asset class level.

    Can you expand on equities being slightly undervalued here. More then ever, I am trying to be cognizant of different valuation perspectives, paradigms, and models but then I read something like this:


    On that front, I am doubly concerned here because on the basis of an ensemble of fundamental measures (normalized earnings, revenues, book values, dividends), the only points between the pre-Depression period and the late-1990’s when the market has been so richly valued were November-December 1972 (before a 2-year market loss of about 50%), and August-September 1987.

    He has missed this entire rally though so I’m inclined more then usual to underweight his opinion, but IIRC Grantham also has a fair value target of the S&P at 850-900ish.

  • I’m also curious on the equity valuation statement.

    Australia came through the crisis well, but is still in a housing bubble (see Edward Chancellor of GMO, “How long has the lucky country got?”, FT March 1st), and is awfully dependent on the Chinese stimulus boom.

    Emerging market local currency bonds have three advantages — backed by governments with better balance sheets, not in dollars, and high yields — but of course are still risky.

    Almost everyone thinks US high-yield is approximately fairly valued. This assessment is based on historical average yields. But current high-yield has a much higher proportion of CCC than historically, so I think it is dangerous to make that comparison.

    Jim Fickett

  • Like Mike C., I’d like to see a little more detail about equities being undervalued. I practice dollar cost averaging, so if there’s an opportunity to grab, I’d love to be first in line.

  • Dallas says:

    Excellent post.

    How do you invest in CA$ and AU$ ST bonds funds? They all seem be traded on exchanges US investors can’t get to, at least not w/o a foreign bank acct.

  • Stocks are cheap on an earnings relative to BBB corporate bond yields. BBB bonds yield around 6.2%, and would need to yield more like 9.4% to compete the earnings growth in stocks.

    That said, stay high quality with stocks. Junk stocks are overvalued here.

    Canada bond ETF — FXC
    Australian bond ETF -FXA

  • maynardGkeynes says:

    bond yields : earnings :: fact : fiction

  • sorry, MGK — earnings yields are related to bond yields: http://alephblog.com/2007/07/09/the-fed-model/

  • Terry says:

    @maynardGkeynes–I am able to track my muni bond’s value on a close to current basis. The prices I see are very close to the prices I sell at and the commission/fee I pay is visible. NTL, I don’t “trade” munis, just take advantage of a healthy gain (10% or better) when it shows up.

    And, yes, VA is a low tax state which won’t change in the remainder of my lifetime. Right now, the budget is taking huge cuts in programs, education maybe most notably, which is not good long term. Still, the state (& most counties & municipalities) is so far from bond default that I’m not worried.

    NTL, thanx for the thoughts.

  • IF says:

    David, I am very surprised you mention FXC and FXA after writing this last year:

  • James Dailey says:

    Hello David,

    I hope you take my comments in the spirit in which it is intended – constructive criticism. Your comments about valuation for corporate bonds and equities relative to corporate bond yields is drenched in circular logic, or a chronic disease amongst many investors I come across that I call “relativism”. It seems to me that such a relativism call is more of a trading judgment than an investment judgment. For example, under what circumstances do 5=6% long term corporate bonds represent absolute value? Historically, they have at that level under a hard currency regime. They would like at present if we are to enjoy stability and neither inflation nor deflation. However, I think that outcome is likely to be remote and would be surprised if you don’t agree. Under inflation they will likely generate poor returns and under deflation do the same due to defaults – treasuries would be the way to go. It seems to me that your assessment of value is according to static factors that are almost certain to be anything but.

    As for stocks, I agree on your classification regarding high quality. I continue to find quite a number of large/mega cap companies trading at single digit P/E’s on normalized or even below normal profit margins AND paying yields in the 4-6%. For example, VZ and T have relatively safe dividend yields that are equal to or greater than the yields on their 10-20 year bonds. The large integrated oil companies are trading at 6-9 times earnings and are priced as if their downstream businesses have zero value and many have yields in the 4-6% range. Many relatively stable utes are at 9-11 times earnings with 5-6% yields

    I think markets may be positioning for a period of bifurcation similar to the 2000-2001 period, only in reverse. Small/mid cap, including value, are extremely over valued at present and we may see large cap quality do very well both in relative and absolute terms during the transition phase until the next crisis arrives.

  • IF, you are right, I forgot.

  • IF says:

    I’ve noticed (and this is currently commented on with regards to the GS/Greece story), that US investors have a really hard time to get access to foreign bonds, equities to a lesser degree. It seems to foreigners have to voluntarily register under the 1933 laws to be able to be sold in the US, but of course many of them don’t care and hence are not available.

    Contrast this with a brokerage account in Germany (or I think most of Europe), where bonds are on the exchange (vs. over the counter) and foreign equities and bonds are available from around the globe. Ultra low liquidity (maybe like US munis), but available to the patient investor.

  • Bob_in_MA says:


    I don’t think you are measuring valuation in your previous post, in the sense of what value do the equities represent. I think it’s measuring something like what valuations would be if today’s earnings and today’s cost of capital were made permanent.

    In 2007, your model told us that IF the credit bubble could be sustained:
    “What P/E ratio would the current BBB bond yield (6.74%) support? I am surprised to say that it would support a P/E in the high 30s; 39.8 for the simple model, and 35.2 for the “slightly superior” one. With the current trailing P/E at 18.1, that would indicate that on an unadjusted basis, the market could be twice as high as it is presently.”

    No offense, but any valuation model that would arrive at that conclusion can safely be tossed aside. For the record, CAPE and the Q ratio were both well into over-valued territory.

    And while your model said stocks were a screaming buy in 2007, it had you out of the market in 1983-84. A time when the market was seriously undervalued by every other measure.

  • maynardGkeynes says:

    @David: The FED model is fine. What I was trying to say is that earnings today are routinely fudged, which is something you can’t do with bond yields, which are stated on the coupon. I seem to recall that even Jeremy Siegel applied something like a 15% fudge factor to reported corporate earnings in his debates with Shiller. I think that’s optimistic — look at GE, the bluest of blue chips, whose main product turned out not to be toasters and TVs, but thoroughly manufactured earnings by means of tricks with GE Capital. Nowadays, when dividends yields are so low across the market, the real world yield from equities is less certain than ever. Maybe not total fiction, but not reliable either

  • Profit margins do look abnormally high; I will have to revisit my thesis. Not sure that accounting shenanigans in aggregate are higher than normal at corporations now.

    As for FXA and FXC, confirmed:one buying these takes JPM credit risk.

  • Russ says:

    Thanks for suggesting your readers hold MMFs. In my view, the zero interest rate environment is tempting many individuals to chase yield. That never ends well.

  • dlr says:

    I’m concerned about the Canadian dollar and the Australian dollar. If the world economy tanks some more oil is going to drop in price again, and that will have a negative impact on both the Canadian dollar and the Australian dollar. And I think we have lots and lots of downside risk that could hurt oil prices— Europe shooting itself in the foot (even more), the US going into a double dip (which I think is inevitable) or as a reaction to China tightening. In fact, I think Australia’s economy is so intertwined with China’s that it is really a China play.

  • dlr says:

    I was talking to a Fidelity advisor and he told me that California doesn’t have the ability to default on it’s debts – it’s written into the constitution, that all revenue flow must go first to schools, and second to debt obligations. Interesting if true.

  • keithpiccirillo says:

    How about a company like TRV? Insurance stocks have yet to catch up to other sectors.
    Trading at $55, just above book value of $50.

  • I own ALL, SAFT, CB and PRE — love insurance here.

  • Lurker says:

    If I were confined to trading U.S. sectors, I would be long insurers from a momentum perspective, using the KIE. keithpiccirillo Says: “Insurance stocks have yet to catch up to other sectors.” Lurker says: what are you looking at???? KIE has outperformed SPY by a HUUUGGE margin, up 115% in the last year.

    If I were forced to select individual insurers from a momentum perspective, they would likely be members of the KIE that David most likely wouldn’t like, players like AFL, GNW, etc.

    If forced to look at fundies for insurer selection, I might start my screening with guys like KINS, VR, RNR, MRH, PRE, OB, HCII, MCY, NYM, FSR, AFL, AWH, PGR, WSH, and ESGR.

    If purely rolling dice:

    I am of the (totally unfounded, BTW) position that HIG is positioning for either a divestment or being acquired, with their recent capital raise to pay off Treasury as a necessary precursor. Personally I think their mixed business model sucks and that they’re a good comm. carrier with so-so personal lines departments and a wannabe mutual fund outfit attached, but somebody might want the “life” business enough to pay for it, and somebody might want the AARP distribution enough to pay for it.

    I am intrigued by many of the smaller Florida-based P&C HO guys. This is a game where you need to understand their strategy and the intricacies of reinsurance pricing, but those guys, some of them are priced like options on their company’s survival. Yeah, I occasionally buy Lotto tickets …