Every now and then, the planets align and someone from the usual
crowd gets some free publicity by finding this portentous . As it
happens, some financial risks are starting to align, and I thought
it would be in the interest of the general public to sound the
I took a look
at which industry groups were most exposed to higher long-term
rates. The list, unsurprisingly, was dominated by REITs, utilities,
and a smattering of consumer staples. A parallel analysis of which
industry groups are exposed to higher short-term interest rates is
much sparser as we have been in a low- and suppressed short-term
interest rate environment for so long that these rates have lapsed
as a meaningful factor.
This last point is a risk in itself: While we are cautioned that
past performance does not predict future results, all data analysis
must be based on available numbers from the past if for no other
reason than the fact that future data are so difficult to obtain.
Mortgage-derivative models did not assess the risk of nationwide
declines in residential real estate properly as no such data sample
existed after the 1930s. When the various systemic-risk mavens
created by Dodd-Frank gather, they should consider this point…but
the betting here is that they will not.
Cost of Capital
Now let's revisit an analysis from
on the weighted-average cost of capital (
) for both economic sectors and for industry groups within the
financial sector. WACC includes the costs of firms' debt, equity,
and preferred stock. The relationship between WACC, profitability,
and returns is not a simple and direct one; staid utility and
consumer staples firms can have both a low WACC and then get
clobbered in a rising-rate environment, or firms with a high WACC
in the technology or energy sectors can have a high WACC as
investors demand a higher return for their perceived risk.
The alignment of WACCs for sectors is roughly what we should
expect. Utilities, telecommunications, and consumer staples all
have WACCs below financials' 7.19%. The WACC of the
(INDEXRUSSELL:RUA) of 8.47% forms the internal Y-axis.
Now let's split the financial sector into its groups. As was the
case in December 2011, the large banks that proved themselves quite
dangerous to the populace have WACCs below the sector's average.
The perception of a government safety net works wonders. The list
of above-average WACCs is dominated by REITs and real
Thus the same stocks with the greatest exposure to both higher
long- and short-term interest rates also are penalized with a
greater-than-sector-average WACC. The question of "which REITs?"
has a fairly simple answer: All of them. REITs had a tremendous run
from the March 2009 low; the
iShares US Real Estate ETF
(NYSEARCA:IYR) has returned more than 244% from the March 2009 low
versus 165% for the
Standard & Poor's 500 Depository Trust
(NYSEARCA:SPY) .That performance was based on free money and the
yield-chasing response thereto. All good things come to an end.