Dan Culloton: Hi, I am Dan Culloton, associate director of fund Analysis with Morningstar. I'm here today with John Osterweis of the Osterweis Fund. John, thank you very much for being with us today.
John Osterweis: Glad to be here.
Culloton: John, in one of your recent commentaries you had mentioned that rising interest rates were not necessarily problematic for a continued rise in equity prices. I'm wondering if you feel the same way after what we saw in May.
Osterweis: I actually do. I think what you saw in May was a knee-jerk reaction to some comments by the Fed that they would at some point in the future start to back down from this very aggressive monetary policy. And the market sold off and then actually has come back in the last few days.
But our thinking for some time has been that interest rates are artificially low because of the Fed stimulus and that the market really hasn't reacted totally to the low level of interest rates, so that if you were to do a dividend discount model valuation on the stock market, at the current level of interest rates, you would get a P/E ratio of somewhere between 25 and 50 times on the market, and the market is currently trading at about 16 times. So the market we think is valuing stocks on a more normalized level of interest rates, not the actual current level, and so as interest rates start to move up that, shouldn't really hurt equities.
Then you have to ask why would interest rates move up, and it's either because inflation has picked up, which we don't think is likely at this point, or because the economy itself is moving forward and unemployment levels have reached the Fed's target, and the Fed believes the economy can sustain growth without the artificial force-feeding that it's doing.
If that's the case, if the economy is moving up, corporate profits should be moving up, and so a slightly higher level of actual interest rates shouldn't really send the market down, because the one thing that's clear is the Fed has no interest in triggering another recession at this point. So markets usually sell off in anticipation of recession, and that's not likely to happen, at least because of Fed actions. I mean it could be other things that send us into recession, but it wouldn't be the withdrawal of life support.
Culloton: So essentially you're saying … the possible ramifications for interest rates may be priced into current equity prices?
Osterweis: I think they are priced in.
Culloton: You mentioned the very robust state of corporate profitability. Profit margins are really at historic levels. They really can't stay there. Do you fear any sort of reversion to the mean in corporate margins?
Osterweis: Probably at some point there will be a reversion to the mean, but the question is, at what point and is it an imminent reversion? And I don't see it as an imminent reversion because of two things: one, there is really no real commodity inflation at this point--given the slowdown in Europe, the slowdown in China, the sluggish growth here--there's not a lot of pressure on commodities. And the second area you would be concerned about would be wage pressures, and given the high level of unemployment, there really isn't a lot of wage pressure here. So I don't see that input costs are necessarily going to rise faster than end prices, which would lead to margin shrinkage. So I think margins can be sustained at this higher level for some time.
Culloton: Before we leave, what's the biggest risk that investors face right now in the market?
Osterweis: I think the most obvious risk right now is probably in fixed income, where there seems in everybody's mind to be an inevitable rise in interest rates. It may be with fits and starts, but I think if you're in the wrong side of the fixed-income market, you're still vulnerable to considerable losses.
On the equity side, I'm actually fairly constructive on equities looking out for the next five to 10 years. Probably the biggest risks would have to do with government finances and whether we're able to move from huge deficits towards a more balanced budget--whether that can happen smoothly.
Culloton: That's another discussion.
Osterweis: And quite a long discussion.
Culloton: Well thank you very much for your time today, John.
Osterweis: Dan, it's my pleasure. Thank you.
Culloton: Thank you.