For the last year, the effective federal funds interest rate has been 0.25%. The federal funds rate is considered one of the most important interest rates in the U.S. markets.
The federal funds rate is used to control the supply of available funds and hence, inflation and other interest rates. Raising the rate makes it more expensive to borrow. That lowers the supply of available money, which increases the short-term interest rates and helps keep inflation in check. Lowering the rate has the opposite effect, bringing short-term interest rates down.
In this incredibly low interest rate environment, there are some investments you’ll probably want to avoid, as well as some better choices for where to invest.
Long-Term CDs or Bonds Aren’t the Way
The average one-year CD is around 0.34%. If you go with a longer-term five-year CD, you may get 1.14%. We know rates are locked for the next few years, but the one-year is nowhere near inflation. With the rate so close to zero, buying a long-term CD locks in long-term to really low rates. Nobody wants to find himself in that predicament.
One thing taught in college finance 101 is that bonds have a strong inverse link to interest rates. That is, when market interest rates increase, the prices of existing bond issues decrease. In addition, the longer it is to the bond’s maturity, the more sensitive its price is to changes in the market interest rate. The longer you’re exposed to the market, the more risk you take on.
Equities and Short-Term Bonds
Low rates are loved by the markets – look at the way they react to any hint of quantitative easing. In theory, if you can borrow money at lower rates, you’re more willing to be a player and grow. Hopefully this action translates into earnings and a rising stock price.
As Investment U bond expert Steve McDonald preaches, short-term bonds work because they’re much less sensitive to changes in rates. Better yet, if you hold it to maturity, the bond’s price becomes less important because you get back the principal. Due to its nature, short-term bond rates aren’t that high, but a modest return still beats one that causes you to lose spending power.
The Interesting Twist
The Fed, as I mentioned before, intends to keep money artificially cheap – keep low rates so that it’ll be easier for people to borrow money, invest it in expensive things of lasting value that require long-term financing, and keep your fingers crossed that this will be a catalyst for a stronger recovery.
But it hasn’t worked out that way. Unemployment hovers at historic highs, so it’s hard to take advantage of these rates when you’re not sure about your income. This isn’t so much of an issue of liquidity but one of confidence.
Despite the uncertainties involved, equities remain one of the better choices if you like other fundamental indicators in the economy. They give a chance to benefit from low interest rates, and generally aren’t expected to decline sharply when interest rates rise.
Understanding the P/E Ratio
Don’t make this amateur investing mistake
In this latest bull market and period of new IPOs, there are a lot of people on the Street clamoring about where a stock is selling or its “multiple.” And they all act as if this number is the end-all be-all.
The reference is to the P/E ratio. While it’s one of the oldest and most frequently used metrics, it can also get you into some trouble if taken out of context.
What is it Exactly?
The P/E ratio measures the relationship between a stock’s price and its earnings, or profits per share. Here’s the calculation:
P/E = price per share/earnings per share (EPS)
You take a company’s stock price and divide it by its last 12 months of earnings per share. This is a trailing P/E. Everyone wants more earnings for every dollar you invest. So in theory, a lower P/E is considered more attractive.
What Does it Tell You?
The P/E ratio gives us a clue to what the market is willing to pay for a company’s earnings. The higher the P/E, the more the market is willing to pay for the company’s earnings – and vice versa.
Some investors interpret a relatively high P/E as overpriced (The best gauge of whether a P/E is high or not is to compare it to very similar industry competitors.) On the flip side, the market may be very bullish about the company’s future and has bid up the stock price – leading to a higher P/E.
A company with a relatively low P/E may be overlooked or ignored by the market. This is the ideal prize for value shoppers. But this same position could mean that the market has driven the stock price down because the company just has bad fundamentals.
An Incomplete Picture
But P/E paints an incomplete picture, and here’s why:
- The P/E ratio usually looks backwards. If one company is able to double its earnings in a few short years while another remains stagnant, the former could be a much better value despite a higher multiple. Yet you wouldn’t know it from the single-snapshot picture the P/E provides.
- The “forward P/E” published by some sources is a better tool, because it uses the next year’s pro forma earnings instead of last year’s earnings. But this picture is still limited since it’s just an educated guess at next year’s earnings.
- Remember that accountants can do some creative things with reported earnings. While one company may report a largely honest number, another may be manipulating earnings per share to meet market expectations.
First of all, P/Es need to be placed in a context that gives them meaning in which they’re compared to competitive companies or to an industry average.
And maybe most importantly, the P/E ratio should never be the only metric used when trying to determine whether a company is currently overvalued or undervalued. It doesn’t matter if it’s a trailing or a forward P/E. No ratio should be used in isolation for that matter.
The P/E becomes more useful if you can get a grasp on just how much in earnings a company will be able to achieve over the coming years. But in order to do this, you’ll need to study the underlying business and understand its margins, scalability and competitive position within the industry.
So long story short, the P/E is a helpful metric. But don’t make the common amateur mistake of letting it be an end-all, be-all valuation metric.