09/20/2016 03:54 EDT | Updated 09/20/2016 03:54 EDT

'Free Money' Interest Rates Are Nearing The Point Of No Return

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Frustrated male trader at work

Perhaps it's because the summer is over and people are a little unhappy about the shorter days and longer nights. Or maybe it's because the distraction of the lake, the beach or the links is over, prompting investors to turn their attention back to the markets.

Whatever it may be, September is known as the cruelest month for stocks, and so far at least, it has proven its mettle. Where things end up going forward remains to be seen, but what has become clear since summer's haze wore off is that the current investing environment is becoming increasingly difficult to navigate.

Indeed, with yield in fixed income having become minuscule, many investors are looking for alternative ways to both earn a half-decent return and, at the same time, protect themselves and their portfolios from increasing market volatility.

"Free money" refers to how central banks have set interest rates very low in the North America and at zero -- or in the negatives -- in many other countries. It costs practically nothing to borrow or invest -- hence the term "free money."

Interest rates in the developed world have not been this low in 5,000 years, and I cannot tell you how many individual and professional investors I have spoken with who are convinced interest rates will remain near zero forever.

We are now in a Bizarro world where continuing ultra-low interest rates are good for stocks, and talk of higher rates alone can send some markets reeling.

It's not too different than in the early 1980s when investors and most "experts" were convinced interest rates would remain in the high-teens and low-20 per cent range forever. Near-term bias dominates most peoples' views, which is to say that whatever has happened most recently is projected to the future.

"Free money" may seem positive, but it has caused many market distortions. Bond markets are in a bubble, and many stocks (especially large parts of the U.S. market) are very expensive, as earnings have not kept up with valuations and investors have put money in equities, especially high dividend paying ones, as they see no alternative. Don't even get me going about residential real estate in Vancouver and Toronto.

I was always led to believe that moderately rising interest rates signaled improving economic conditions as well as good equity markets, and declining interest rates meant deteriorating economic conditions and lower stock prices. We are now in a Bizarro world where continuing ultra-low interest rates are good for stocks, and talk of higher rates alone can send some markets reeling.

For value investors, such as ourselves, who have so far chosen to carry a higher-than-normal amount of cash, what is desperately needed is a broad market correction and/or an increase in corporate earnings. Earnings are basically in an "earnings recession" at the moment, meaning that we are seeing little to no growth in profits, and yet stock prices continue to rise thanks to "free money."

To me, it is looking a lot like 1999, when investors were only in the stock market because there was nowhere else to be, and didn't want to -- and frankly, couldn't -- miss out on the rally. Or so they thought.

federal reserve building

San Francisco Federal Reserve Bank. (Photo: ED FREEMAN VIA GETTY IMAGES)

We believe that the current "free money" policies around the world of negative or zero-ish per cent central bank rates have not worked and do not work, and cannot understand why central banks continue to follow this course. The definition of insanity is doing the same thing over and over again and expecting a different result.

We think the Federal Reserve is well behind the curve and that interest rates should be higher -- and can't believe a 0.25 or 0.50 hike in rates will kill the U.S. economy. We don't know if the Fed will raise rates this year or next, but we do know it is necessary and long overdue. In the meantime, the bond market will do their work for them.

One way to protect yourself as an investor is to diversify and be prepared for several possible outcomes. For example, in addition to the value stocks we own, for most of our clients we have some short bonds, some 10-year bonds, some perpetual preferred shares and some rate reset preferreds -- rate reset preferreds will win if and when rates go up.

Of course, nobody knows for certain when rates will finally change their 30-plus year downtrend. We can only hope they do reverse course and start to modestly rise, as we believe the longer this current condition persists, the uglier the end could be.

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