A Winning Strategy Earnings, interest rates, investor psychology and the stock market
Mario J. Gabelli
From the Print Edition:
Kevin Spacey, Jan/Feb 02
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Nominal interest rates, comprising "real" and "inflation" components, reflect the time value of money. There is a set schedule regarding the timing and the amount of cash flows from a straight bond. You get coupon payments with the highest degree of certainty -- at least with U.S. Treasuries -- on prescribed dates and your principal paid back at maturity. When you invest in stock, there is uncertainty with respect to the timing and level of the company's cash flow. Uncertainty means risk. Consequently, as a stock investor, your expected return (which unfortunately is not always realized) exceeds that which is available from a high-quality bond. This incremental return is called the "equity risk premium" and is one reason why interest rates are a very important influence on the general level of stock prices. To value a business, you must make an attempt to calculate the present value of a company's future cash flows.
Generally, low interest rates and low inflation support higher price-to-earnings (P/E) multiples and thus higher stock prices. The converse is also true. This historical relationship is shown on the chart below.
Consequently, rising rates are usually a negative for stocks and declining rates are usually, but not always, a positive. Declining rates may not prevent prices from falling if corporate profits are in free fall, a situation we experienced in 2001. Similarly, rising rates are not always bad, particularly in the early stages of an economic recovery when sharply rising earnings accompany them. But there is little doubt regarding the connection between the level and direction of interest rates and stock prices. The bull market in stocks that began in August of 1982 and continued for most of the next 17 years was driven by the combination of falling interest rates and rising profits, albeit the connection was not always in lock-step. It was almost too good to be true as the Dow Jones industrial average bolted from about 800 to over 11,000.
The discount rate used to calculate the present value of a company's cash-flow stream can be just as important as the earnings themselves. A simple example is to calculate the present value of $10,000, 10 years from now, with interest rates at both 15 percent and 5 percent. In a high-rate environment, using a 15 percent discount rate, the $10,000 of earnings a company generates 10 years out has a present value of $2,472. In contrast, using a 5 percent discount rate gives the earnings a present value of $6,139. In other words, a promise to receive $10,000 in 10 years has a higher value in current dollars when interest rates are low.
Thanks to the mathematics of compounding, lower rates are particularly positive for high-growth stocks because the present value of a rapidly rising earnings stream will be higher than the present value of a slower growing earnings stream, everything else being equal.
So the moral of the story is that declining interest rates are good for stocks in general but even better for "growth" stocks. The current bond yield environment is potential rocket fuel for quality growth stocks. It is also a strong tonic for stocks with reasonably good dividend yields, assuming such dividends are secured by earnings that cover the dividend payments with a healthy margin of safety.
Many years ago most stocks provided dividend yields that exceeded bond yields, making stocks attractive for income generation. Investors were not as comfortable with stocks then and demanded robust dividend payments to induce them to buy stocks. With money market and savings account yields hovering at or even below 2 percent, many investors can easily increase their income generation by reallocating assets to stocks with current dividend yields in excess of 2 percent. As dividends grow over time, the investors' income stream will grow in tandem. If income is an investment priority, it's time to think about adding some stocks to the mix.
Of course, intrinsic value and equities pricing are horses of two very different colors. Remember the emotional Mr. Market often values stocks materially above and substantially below intrinsic value. So, investor psychology will have a major impact on market trends in the year ahead.
Are investors ready to come back to the stock market? I think so. Investors are going to have to deal with another quarter or two of ugly earnings and ongoing concern over terrorism -- the fear factor that ultimately resulted in a classic "flight to quality" in the third quarter. However, when the political and economic dust settles, fear will likely give way to greed that will not be satisfied by today's anemic returns from bonds and money market funds.