Friday, August 6, 2004

From an irate reader:

"I enjoy reading your Investment Newsletter. However... I have got to point out that interest rates are going nowhere but up. As you know, bond values move inversely to the interest rate... I can't imagine why anyone would buy a bond in the current environment, or why you would not mention the effect of rising interest rates in Letter #358." ~ M.D.W., Alabama

Here's my big opportunity to show you what's really going on...

There are three things that everyone believes...

1. Interest rates are at historic lows.
   
   
2. Interest rates are headed up.
   
   
3. Interest rates can't go much lower.
   

Today, I'll show you why all of these beliefs are wrong.

Then I'll challenge you to do something about it. Your beliefs will change. So, will you act? Most of you won't. It will take a big man to go against the common wisdom. But financial markets have an interesting way about them... just when the common wisdom has taken hold the strongest, it's flipped on its head. Let's get started...

1. Everyone Believes Interest Rates Are at Historic Lows

I put together a chart of U.S. and British interest rates going back to 1720. These are long-term interest rates. You can clearly see that the average long-term interest rate, going back to 1720, has been about 4.7%.

Over the last 200 years in the U.S., long-term interest rates have been below 6%. Only during the last few decades (and for a brief moment during the founding of our nation) have interest rates been higher than 6%.

U.S. interest rates are not at their historic lows. They are in line with their historic average, around 4.5%.

In your own life experience, interest rates are as low as you've seen them. But that is only a few decades of hundreds of years of interest rates. Everyone else believes that interest rates are at historic lows. Now you know better.

2. Everyone Believes That Interest Rates Are Headed Up

All you hear on the news is how the Fed is going to raise interest rates. And that, of course, will most likely happen. But what interest rate is it going to raise?

This is where people get confused... Short-term interest rates are at an extreme - the Fed lowered short-term rates so banks can get money at 1%. But long-term rates, like mortgage rates, are much higher, around 6%.

Here's where the confusion comes in... short-term rates are headed higher... they could go to 2%, for example. But long-term rates may be headed lower... mortgage rates could go to 5%, for example.

Generally, this doesn't happen... generally, long-term interest rates and short-term interest rates move in the same direction. But the Fed lowered short-term rates to an extreme low, and has to raise them back to "normal." Meanwhile, long-term rates could easily go either way... they're not under the control of the Fed.

3. Nobody Believes That Interest Rates Can Go Lower

Now, this is a ridiculous assumption! Let me give one simple example:

We've only had one other major stock market bubble in a developed country in our generation... and that was Japan's stock market peak on Dec. 29, 1989. At the time of Japan's stock market peak, long-term interest rates in Japan were around 6%. As the bubble has burst over the last 15 years, long-term interest rates in Japan actually dipped below 1%!

I created a chart for you today to compare interest rates in Japan and the U.S. I lined up the peak in Japanese stock market with the peak in the U.S. stock market. The similarity so far is uncanny...

Long-term interest rates in the U.S. were at 6% at our stock market peak, too. And today they're closer to 4.5% in the U.S. - almost exactly where they were four and a half years after Japan's stock market peak.

I'm not saying what happened in Japan will happen here. I just find it interesting that we have only one other stock market bust in a developed country in our generation for comparison. And in that country, long-term interest rates dipped below 1%!

The point is, YES, interest rates can go much lower.

So, Where To From Here?

There are few things you can be certain of when it comes to investing. But one thing nearly everyone is certain of is higher long-term rates.

But today I showed why the common wisdom about interest rates is plain wrong. You'd have to agree based on the evidence above. So what are you going to do?

In short, you should buy some bonds. Safe bonds. I like long-term Treasuries (an easy way to buy is TLT), and I also like decent corporate bonds (LQD is easy to buy). You'll make 5% interest in these, with the possibility of some pretty decent capital gains.

It will be tough to buy. You'll be alone. A maverick. People will give you a hard time. But you can only outperform the crowd by not doing what the crowd is doing.

Think hard about it, and then do it!

Today's IU Cribsheet

• Above I recommend a couple bond investments that should do well in the months ahead. One of them is iShares Lehman 20+ Year Treasury Bonds (symbol: TLT), and the other is the iShares InvestTop Corporate Bond (symbol: LQD).

Good investing,

Steve