A Winning Strategy Earnings, interest rates, investor psychology and the stock market
Mario J. Gabelli
From the Print Edition:
Kevin Spacey, Jan/Feb 02
(continued from page 1)
How good is good -- what happens to earnings growth rates once we emerge from this period of uncertainty?
Let's examine the current environment and try to answer the first three of these questions. The economy is in recession and corporate earnings are anemic. However, dealing from positions of strength -- subdued inflation and budget surpluses -- the Federal Reserve and federal government are pulling out all the stops to reinvigorate the economy. The Fed has injected massive liquidity into the system and as I write, cut short-term interest rates 10 times in 2001 for a total of 4 percent, leaving the Fed Funds rate at 2 percent as of early November. Perhaps more importantly, the Treasury has announced it will no longer be issuing 30-year bonds. This has brought long-term interest rates down, further fueling the home-mortgage refinancing boom that is putting a lot of money in consumer's pockets. Lower long-term interest rates also bring down the financial costs for corporations. This will have a favorable impact on future operating earnings, and eventually encourage business investment. Although there is currently some squabbling between Democrats and Republicans, Congress will pass a substantial economic stimulus package. Our conclusion is that we will experience a relatively modest, short-lived recession, with the economy and corporate earnings starting to recover in the second half of 2002.
How good is good? Corporate America has cut a lot of fat from the bone, which will create earnings leverage once demand recovers. Consequently, I think earnings will climb sharply in 2002. Over the long-term, I believe earnings growth will approximate 6 to 8 percent. If earnings recover as I anticipate, lower interest rates will have a beneficial impact on the present value of equity assets.
Interest Rates 101
Let's spend a few moments looking at what happens when interest rates decline:
Reduced Financial Costs. This helps highly leveraged companies by reducing interest outlays.
Improved Demand. Lower rates help stimulate demand for traditional, interest-sensitive economic sectors, including residential housing, a key and visible component.
Focus on dividends. Clearly, higher-yielding stocks with reasonable growth prospects benefit from investors who seek higher yields than they are getting from savings accounts.
Higher Asset Values. Lower rates bolster the value of assets.
Interest rates have declined to levels we have not seen in a long time. Short-term interest rates have not been this low since 1961. The story is similar for long-term interest rates. The 30-year Treasury bond was first issued in 1978 and it carried a coupon of 8.00 percent. These were known as the "8s of 08." Today, with a weak economy and the recent decision by the Treasury to halt the sale of 30-year bonds, we are looking at sub-5 percent yields on long-dated Treasury debt. In 1981, the 30-year bond, referred to by some as the "long guy," carried a 15 percent coupon; and 5-year Treasury notes were sold with a coupon of 16.125 percent. Rising productivity, low inflation and better fiscal and monetary discipline on the part of the Congress and Federal Reserve System all contributed to the truly incredible slide in interest rates.