stock prices in a rising interest rate world (II)

why should stock prices decline if bond prices do?

The main argument that they should is an economic one–that demand for stocks (or bonds, for that matter) is only one expression of a more basic demand, a desire for savings.  That demand expresses itself in interest in liquid vehicles like stocks, bonds, or cash, as well as illiquid ones like real estate or hedge funds.

Allocation among investment vehicles is partly a function of individual preferences, partly one of price/expected return.  In theory, investors change their allocation among liquid alternatives like stocks, bonds and cash depending, at least to some degree, on their perception of relative value.  So, if bond prices go down (bonds become cheaper), investors will allocate more new money to bonds and will sell some of their (now relatively more expensive) stocks to buy bonds.  Professional arbitrageurs may join in, too.  This selling makes stocks go down, too.

In the real world, however, this doesn’t always happen.

Look at recent history.  Stocks are up 150% over the last four years, while individuals have shunned equities and poured money into bonds.  No judgment of relative value there.  No consideration of potential future returns.

What about the AAPL bond offering?  Only a few weeks ago, people were more than happy to buy AAPL 30-year bonds with a(n ultra-low) coupon of 3.85%, even though the Fed had been making it clear for a long time that the normal rate on cash should be higher than that.  No long-term thinking here.  Those bonds are now more than 10% lower, as sentiment has changed.

end of recession vs. end of the business cycle

When the economy is overheating and chronic inflation threatens (not the situation we’re in now), the Fed raises rates.  Bond prices drop.  Anticipating lower profits, stocks also fall.

At the end of recession, on the other hand, the Fed raises rates from emergency lows back to what it judges to be normal (inflation + a real return for lenders).  Bond prices fall.  Historically, in this situation stock prices don’t.  Historically, they go sideways to up, because the Fed’s intention is to remove emergency assistance, not to slow profit growth.

It seems to me that this is a key difference that Wall Street is overlooking so far.  I can understand why the bond market is upset, though.  I would be too if I thought that thirty years on cruise control, riding the gravy train of ever-lower interest rates, is over.

does the absolute level of interest rates matter?

Jim Paulsen’s comments that I wrote about yesterday made me think back to a simpler time–the mid-1980s.  Arguably, you have to go back that far to get a period when markets weren’t distorted by Alan Greenspan’s penchant for very loose money policy.

Back then, it seemed to me that investors looked carefully at the return they could get on a cash deposit vs. what the stock market might offer.  If money markets began to yield, say, 5%, some market participants would begin to shift money out of stocks and into cash.  The idea seemed to be that a 5%, 0r a 6%, return that was very likely over the following twelve months and that involved very little risk was preferable to a potential 8%-10% return that required taking the risk of owning stocks.

I don’t know, but it may be that the absolute yield on cash will be a more important consideration again today for stocks than their relative value vs bonds.  If so, in today’s world, a 4% yield on cash might be the threshold for switching out of stocks.  Maybe it’s 3.5%.  But it’s certainly not the current zero.

recent world currency movements: stock market implications

dramatic changes

Although currency movements sometimes can often be overlooked by a stock market investor immersed in the hustle and bustle of day-to-day trading action, there have been a couple of whopping big moves in major currencies over the past half-year.

Since late July 2012, the euro has risen by 12.5% against the dollar.  Over the same time span, the yen has fallen by about 16.5% against the greenback.  A quick bit of multiplication tells us this also means that the euro has risen by about 30% against the Japanese currency.

To my mind, there’s no really satisfactory general economic theory about how currencies work.  But to give a sense of perspective, inflation in Japan has been, say, -1% on an annual basis over the second half of 2012.  We’ve had +1.5% in the US.  Euroland has experienced a 2.5% rise in the price level.  Inflation differentials imply that the yen should be rising against the dollar at a 2.5% annual rate and against the euro by 3.5%.  The euro, in turn, should have weakened by 1% against the dollar and 3.5% against the yen.  The actual outcome has been far different.

Of course, there are reasons for the spectacular assent of the euro and the plunge of the yen.  Until around mid-year, many observers thought Euroland was coming apart at the seams and rushed to get their money out before the demise.  I’m sure there was more than a touch of flight capital mixed in the outflows.  Thanks to Mario Monti’s and Angela Merkel’s actions indicating the political will to save the euro, capital flows have reversed in spectacular fashion.

Newly-elected Japanese Prime Minister Shinzo Abe made it a central plank of his campaign for office that he intends to force the Bank of Japan to print lots of money.  Why?   …to weaken the yen and to create inflation.  The move could easily end in eventual economic disaster, but for now its main effect has been to drive the Japanese currency down a lot versus its trading partners’.

stock market implications

Generally speaking, a rising currency acts to slow down the domestic economy.  A falling currency gives the economy a temporary boost.

Currency changes can also rearrange the relative growth rates of different sectors.  The best-positioned companies will be those that have their sales in the strongest currencies and their costs (e.g., labor, raw materials, manufacturing) in the weakest.


The decline of the yen has given Japanese export-oriented firms a gigantic relative cost advantage against European competitors, and a significant, though smaller, one against US rivals–or those located in any country that ties its currency to the US$.  Anyone who sells products in Japan that are imported, or made with imported raw materials, has been crushed.

We’ve seen this movie before, however, on a couple of occasions.  It’s ugly.  Domestic firms lose.  Exporters will make substantial profit gains in the local currency.  But from a stock market view, that plus–with the possible exception of the autos–will be offset for foreigners by currency losses they have/will endure on their holdings.  Stocks in even the most advantaged sectors will deliver little better than breakeven to a $ investor, and will certainly rack up large losses to anyone interested in € returns, in my view.


The EU has already had a return-from-the-dead rally, where stocks of all stripes in the economically challenged areas of southern Europe have done well.  The message of the stronger currency is that importers, or purely domestic firms in defensive industries will fare the best from here.    Although I think the preferred place to be from a long-term perspective is owning high quality export-oriented industrials, the rise of the euro has blunted their near-term attractiveness.  One exception:  multinationals based in the UK, because sterling hasn’t participated in the euro’s rocketship ride.

Ideally, you’d want a firm that imports Japanese goods into the EU.

the US

Americans are less accustomed to thinking about currency effects that investors in other areas, where their effects are more pervasive.  With the dollar being in the middle between an appreciating euro and a depreciating yen, currency effects will be two-sided. Firms with large Japanese businesses, like luxury goods companies, will be losers.  Firms with large European assets and profits, like many staples companies, will be winners.  Tourism from the EU will be up, from Japan, down.  One odd effect, which I don’t see any obvious American publicly listed beneficiary–the decline in the yen is causing the cost of living for ordinary Japanese to rise sharply, since that country imports so many dollar-price raw materials.  To offset that effect, Japan is beginning to weaken protective barriers that have kept much cheaper finished goods (like food) from entering the Japanese market.  Doubly bad for Japanese farmers, though.

are political mists clearing in Washington?

The US securities markets are closed for Martin Luther King Day.  I’m going to make only a brief post–and one not as directly associated with finance as usual.


As a growth investor, I’m a big believer in progress through creative destruction.  I think the rate at which such change occurs accelerated during the Cold War period after WWII, and accelerated again when China decided to ditch central planning in favor of Western economics in the late 1970s.

Change isn’t easy.  The forces of the status quo–the current economic and political leaders–in every economy are very powerful.  They oppose change in any way they can, because it’s in their own economic interest to do so.   In the emerging world, crunch time typically comes when the supply of new workers for labor-intensive export-oriented manufacturing  (most often textile) is exhausted.  Wages begin to rise.  Operations become less profitable.

In theory, it’s clear what has to be done for the national good–migrate to higher value-added industries by worker retraining and by shifting government efforts toward creating infrastructure that attracts more sophisticated foreign companies willing to transfer technology.

In practice, the corporate and government beneficiaries of the way things are now use their clout to stop this from happening.   Many times, because they’re rich and powerful, they get their way–to the long-term detriment of the local economy.

In the developed world, the prime example of the dysfunctional triumph of the status quo over progress is Japan.  Once an incredibly dynamic economy, Japan has spent almost the past quarter century protecting the political and industrial establishment of the late 1980s.  The result has been decades without economic growth, an industrial base in shambles, a sharp decline in the Japanese standard of living and the piling up of an immense government debt.   Ugh!

To my mind, the EU has already traveled a significant way down the same path.

The US, although at an earlier stage,  appears to me to be following suit as well.  This despite the increasingly intense dissatisfaction of the electorate, expressed mostly as unhappiness with continuing deficit spending.

Pretty scary stuff.

Very recently, though, Washington appears to be having second thoughts about what it’s dong.  The Republicans are now saying they won’t repeat last year’s fight in Congress over increasing the debt ceiling.  The Democrats are saying they’ll prepare a budget that includes spending cuts.  So we may be seeing some willingness on both sides to give up their rigidly partisan, protect the status quo, positions.

Certainly, it’s very early days.  But what significance would a movement toward common sense and compromise in Washington have for stocks?  The world already knows that the dysfunction story ends in an economic disaster.  This possibility get expressed in investors paying  a lower price earnings multiple for US stocks than they otherwise would.

How much multiple expansion would a less self-destructive Washington engender?  One point?    …two?  Each point would represent about an 8% increase in the market level.  So there’s a lot at stake.

Shaping a portfolio for 2013 (vi): putting the pieces together

another up year in 2013?   …most likely,

…though not by a huge amount.  Earnings growth for publicly listed companies in the US is likely to be up, but not by as much as in 2012.  I’m thinking up 7%, up 8% for the S&P 500.  Add a dividend yield on the index of, say, 2.5% and the likely total return from owning stocks this year is around 10%.

I find it hard to identify any obvious–or not-so-obvious, for that matter–macroeconomic factors that might upset the apple cart. Continuing partisan infighting by the White House and Congress that delays or derails the effort to get public finances in the US under control is my biggest worry.  I’m not sure how to quantify that and incorporate it into strategy, however.  I think both positive and negative developments will be reflected through expansion or contraction of the market PE multiple, rather than in changes in the composition of corporate earnings.

the worst is probably over in the EU,

as the area moves in fits and starts toward closer fiscal union.  Europe is still in recession, though, so no aggregate economic growth until the second half.

The surge in EU markets that has pushed them up by about 25% over the past six months in anticipation of further concrete structural reforms out of Brussels/Berlin may well be over for now.  If so, markets may move sideways in the absence of further political progress.

currency or stock price?

Financial markets can respond to further positive political developments from Brussels/Berlin either by bidding up stocks or by bidding up the euro.  I think it’s impossible to know the proportions of one or the other that might occur.  How the markets react to news makes a difference, though:

–The latter would be especially good for US-based companies that have large EU exposure, like personal care or staples firms.  But it would be bad for EU-based multinationals that have large exposure outside the EU, whose foreign-based profits would be worth less in euros.

–In in the former case, the relative beneficiaries would be reversed.

I think the EU is a place to underweight this year.  I’m choosing to hold one or two EU-based multinationals.  So far, I’m keeping with the UK, on the idea that £ is unlikely to be a strong currency, except against the ¥.

the US isn’t this year’s economic locomotive

Last year, we weren’t spoiled for choice, as they say, in the search for countries whose economies would be maintaining or increasing speed.  Emerging nations were downshifting to prevent overheating.  And the EU was falling under the weight of Greece, Spain and Italy.  So the US was pretty much it.  This year, in contrast, the US appears to be in the early stages of settling in for a long period of fiscal retrenchment.


emerging markets are back

Together, higher interest rates and a cooling off of the developed world have lessened the danger of economic overheating in developing nations.  China has also passed through its once in a decade policy interregnum while the leadership of the Communist Party changed.  Throughout the developing world, as a result more growth-friendly economic measures are being put into place.

This should be good for stocks in the Pacific Basin, especially for China-based companies listed in Hong Kong.  Industrial commodities, with the possible exception of energy, should be perking up, as well.  So, too, US-, and, depending on the €, EU-multinationals with emerging markets exposure.

the US–all about focus

I think outperforming the S&P 500 during a belt-tightening year will be all about making choices, in two senses. The first is to opt for firms with businesses outside the US rather than inside.  The second is to laser in on hot spots of domestic growth that develop on an otherwise blah landscape as consumers try to make their dollars stretch a little farther.

Houses and home appliances are in, jewelry and restaurant meals are out.

Lower income families are, as usual, out.  So, too, are the chronically unemployed.  The over-55 set, whose incomes have been sacrificed for a half decade to fight the financial meltdown, continue to be on the outside looking in, as well.   For this year, add the very wealthy to this list, based on their increasing taxes.

lower energy prices in the US

This is good for consumers, good for the developers of unconventional sources of oil and gas, good for industries, like chemicals, that use lots of petrochemicals for fuel or feedstocks.  Bad, on the other hand, for holders of traditional oil and gas assets, especially in the US.  (More about this phenomenon in a later post.)

Check out last year’s putting the pieces togetherif you want.

Shaping a portfolio for 2013 (v): S&P 500 performance this year

 S&P 500 earnings

According to the research firm Factset, the Wall Street consensus is that earnings per share for the S&P 500 index will amount to around $103 for 2012.

For this year, brokerage house equity strategists (a “top down” view) are projecting eps for the S&P of about $109.  Aggregating the company earnings projections of brokerage house industry specialists (a “bottom up” view) into an overall S&P forecast yields an eps figure for the index of $113.

If Wall Street is correct about the 4Q12 earnings now in the process of being reported, the S&P has achieved about a 7% year on year eps gain in 2012.  (For what it’s worth, the base case for 2012 profits I came up with in my Shaping… posts a year ago was 7.5% growth.)

Strategists are expecting a slight deceleration in eps gains for this year, penciling in a 6% growth rate. Industry analysts are more bullish (as they usually are).  Their collective wisdom is that the S&P will post close to a 10% advance.

my take

In looking at the S&P, it’s important to realize than only half the index profits are sourced in the US.  The other half comes, in roughly equal parts, from Europe and emerging markets.

the US:  As I wrote a couple of days ago, real GDP growth in the US is probably going to be only about 2% this year.  This implies nominal GDP growth of around 4%.  Profit growth for publicly listed companies, which tend to be the best and the brightest, should be significantly higher. On the other hand, autos and construction, two large industries which I think will be among the better growers, have little direct stock market representation.  Let’s say 5% eps growth.

the EU:  Zero is probably the right figure for profit growth.  If the EU continues to make progress in trying to shape a closer fiscal union, however, the € could continue to rise in value vs. the $.  That would create currency gains for US firms with EU exposure.

emerging markets:  Recent macroeconomic reports, as well as anecdotal evidence, suggest that emerging markets–especially those in the Pacific Basin–are beginning to reaccelerate.  I think a 20% earnings gain is very easily achievable.

Adding this all up:

US:  5% profit growth, a 50% weighting  = contributes 2.5% to overall S&P eps growth

Europe:  no growth, 25% weighting   = contributes nothing

Rest of the World:  20% profit growth, 25% weighting   =   contributes 5.0% to overall S&P eps growth

Total:  7.5% eps growth.

On the surface, this result–the same number as last year–may seem weird.  There’s no way that the US is going to have as good a year for GDP in 2013 as it had in 2012.  However, the point to note is that +7.5% doesn’t have very much to do with domestic profits.  It has much more to do with an end to contractionary government economic policies in China et al, resulting in greatly improving profits from the international divisions of US-listed multinationals.

the market multiple?

During 2012, the S&P gained 13.4%, ex dividends, on a 7% increase in eps.  The remaining gain of 6% or so is due to price earnings multiple expansion.  In other words, despite all the “death of equities” hysteria in the financial media, investors are willing to pay a higher price today for a dollar of S&P earnings than they were a year ago.

Are we at the end of possible multiple expansion?

No one knows.  We can say, however, that on a relative basis, the S&P is still trading much more cheaply than bonds.  The traditional comparison is to look at the interest coupon on government bonds vs. the earnings yield (1 ÷ PE) of the market.  The two should be roughly equal.

As I’m writing this, the 30-year Treasury is yielding 3%.  The S&P has an earnings yield of 7.1%, based on 2012 eps, and 7.7%, based on 2013.  The two yield figures are miles apart, a situation last seen in the US in the 1930s. If we use the 10-year, now yielding 1.9%, as our proxy for the bond market, the disparity is even greater.  It’s possible that any future adjustment will occur solely through bonds becoming cheaper, with stocks never becoming more expensive.  But that’s not usually the way things work in the securities world.

There’s a second argument to be made for multiple expansion.  It’s that the relatively modest S&P multiple is directly related to the parlous state of economic policy coming out of the White House and Congress.  That is to say, today’s stock prices already discount to some degree the future loss of national economic growth and wealth that’s now being cemented into place by the failure of both political parties to address pressing economic concerns of our international competitiveness, continuing high unemployment and continuing deficits.  Were Washington to begin to address these serious structural problems, I think the stock market response would be prompt and positive.  We can always dream.