Tuesday, April 16, 2013

Stock Prices, Earnings and Interest Rates ... Are Stocks Overvalued, Undervalued or What? ... And How Can We Tell?

Yesterday the stock market nosedived.

Gold prices, oil prices and most other commodities fell into the dumpster as well.

Of course, Patriots' Day and the Boston Marathon were ruined yesterday by an act of terrorism. Some people really are crazy, and there is genuine evil in the world. Let's hope and expect that the idiots who did this are caught soon and punished to the full extent of the law.

But instead of dwelling on what's bad in America and the world, we've decided to zero in on the outlook for stock prices today. In that regard, let's attempt to discern whether stocks are a buy, sell or a hold for individual savers and investors, both young and oldsters alike.

And for those who may be familiar with my long held views, I'm still very much on the buy and hold side of the argument. Nevertheless, it's always a good idea to review the reasons in support of any long held opinion, so we'll do just that herein.

Are stocks overvalued at today's levels and headed for a fall? Or are they fairly valued or even undervalued today?

And how do we know? Well, it's always an interesting question to ask ourselves, and while nobody knows the future, there are simple ways of looking at the relationship between stock prices, company earnings and interest rates.

The price-to-earnings multiple (P/E multiple) is the result of dividing the price of the stock or the market as a whole by the earnings of the individual company or the market as a whole.

For illustrative purposes only, let's assume the S&P 500 will earn $100 this year and that its price level is 1500. In that case, the P/E for the market is 15.

As a result, the earnings yield of the market, which is simply the reciprocal of the P/E ratio (1 divided by 15 in our example), is approximately 6.7%.

Then we'll take the bond yield on a ten year treasury bond and compare that yield to the earnings yield of the market as a whole. That ten year treasury is now less than 2%.

When the earnings yield of the overall stock market (NOT dividend yields) is substantially higher than bond yields, this broadly indicates that the stock market is fairly or undervalued, depending on the size of the gap.

The straightforward arithmetical comparison of earnings yields (NOT dividend yields) on stocks to bond yields reveals simply that 2% is less than 6.67%. And even discounting for a 'more normal' 4% or 5% bond yield on the ten year treasury bond as the economy recovers, 4% or 5% is still substantially less than 6.67%.

Thus, stock prices in relation to bond yields are relatively cheap. And they will be even after interest rates climb again to more 'normal' levels as economic conditions improve.

Meanwhile, interest rates won't go much higher until the economy is doing better, and by then company earnings will have improved substantially.

Thus, rising interest rates in a recovering economy aren't a bad thing but a good thing and an indication of a strengthening economy. As such they reflect a healthier economy with growing company earnings, growing jobs and a generally improving financial situation condition for individuals, companies, investors and the nation as a whole.

And that's what Rethinking Rising Rates makes clear:

"Worries that the economy will fall into recession are fading. Now, many investors are bracing for the day when interest rates start to rise, ending a three-decade-long bull market in bonds.


The conventional wisdom is that rising interest rates are bad for stocks, because stock prices are determined in part by their valuation relative to Treasurys. When bond yields rise, bond prices fall. That, in turn, makes stocks look that much more expensive.

But if history is a guide, the first wave of rising interest rates could actually signal higher stock prices, at least for a while, say some analysts.

The first increases in interest rates might come now that the possibility of another severe economic downturn seems unlikely, says James Paulsen, chief investment strategist at Wells Capital Management, which oversees around $330 billion.

Valuing Companies

A common method of valuing companies is to divide their share price by their last 12 months of earnings, known as the price/earnings multiple. On this measure, the Standard & Poor's 500-stock index has a P/E multiple of about 15.2, according to market data provider FactSet.

According to an analysis by Mr. Paulsen, since 1950, when 10-year Treasury yields already have been above 6%, a one-percentage-point increase in Treasury rates led to a P/E decline of about 1.5—for example, from 15 to 13.5.

But when yields were below 6%, a one-point increase in yields caused P/Es to jump by about 3.25. Assuming earnings stayed the same, such a P/E jump would lead to stock prices more than 20% above their current level.

Investors seem to be "seeing through" the current 10-year Treasury yield of 1.7% to the yield that might exist if the Federal Reserve weren't in the midst of a massive bond-buying program, says Seth Masters, chief investment officer of Bernstein Global Wealth Management, a unit of AllianceBernstein, which oversees about $443 billion.

So, as rates rise, the first couple of points of rate increases might merely bring Treasury rates closer to where investors already assumed they should be, without a big impact on the stock market, he says, though there might be short-term jitters.

The rise could be much smaller. The S&P 500's current P/E multiple already is at the level that would be expected if 10-year Treasury rates were above 3%, Mr. Paulsen notes. In fact, between 1950 and now, when Treasury rates have been below 4%, the average market P/E has been about 14.

Whether rising rates lead to rising stock prices also will depend on why rates increase, notes Aswath Damodaran, a finance professor at New York University's Stern School of Business who has looked at the relationship between Treasurys and stocks.

If interest rates rise because the economy is improving, stock prices might indeed go up. But if it's because inflation fears are rising, stocks could fall, he says. "Interest rates don't rise for no reason," he says.

Less certain is how stocks might react if 10-year Treasury rates were to rise more than a couple of percentage points or if the change happens quickly, Mr. Damodaran says.

Although Mr. Paulsen's research has shown that P/Es start to drop once interest rates rise past 6%, Mr. Damodaran says that this time around, the pivot point might be lower, because U.S. economic growth in the future might be slower than it has been in past decades.

Markets also have come to expect lower inflation rates than were seen in the 1960s and 1970s, which could bring the turning point lower, he says.

Of course, if earnings fall, stock prices can drop even if P/Es rise. Over the next 12 months, analysts expect S&P 500 earnings to rise about 9%, according to FactSet.

A more reasonable P/E increase might be to about 16.5, the S&P 500's historic median, though even that might be a stretch for this year, says Stuart T. Freeman, chief equity strategist for Wells Fargo Advisors. . . . investors will be best served by keeping a higher-than-usual allocation to stocks and less money in bonds, Mr. Freeman says.

"Once the economy looks a little less fragile, investors are going to be looking back happy to have been overweight in equities and underweight in fixed income," he says."

Summing Up

While the only accurate answer about the near term direction of stock prices and interest rates is that they will fluctuate, history suggests that share prices will increase over time and that their fair values are correlated to both earnings and long term interest rates.

Here's a rule of thumb for individual investors to consider. If long term interest rates are 5% or lower, the market's P/E multiple should be generally be between 15 and 20.

Thus, the key uncertainties in valuing current share prices are future expectations for earnings, inflation and interest rates. 

And if the economy is expected to be improving, then earnings will increase. When interest rates are ~5%, $100 in earnings and 1500 on the S&P 500 go together. So do earnings of $120 and 1800 on the S&P 500. And if earnings of $120 are accompanied by an interest rate level of 4%, well, maybe that's worth 2,000 or so on the S&P 500. Plus a growing stream of cash dividends, of course.

Thus, a beginning interest rate level of substantially less than 5% when combined with an improving economy and a favorable outlook for increased corporate earnings suggest that the current market level based on a price to earnings multiple of 15 times earnings is still considerably undervalued.

And that's exactly where we are today.

You can listen to the gloom and doomers if you want, but I don't share their point of view.

Of course, unforeseen unfavorable world events and other surprises may lie ahead to prove me wrong, such as what happened in Boston yesterday, but that's always a possibility --- sadly.

For long term oriented investors, the future is always somewhat unpredictable, of course, but the probabilities aren't.

That's my take.

Thanks. Bob.

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