Many an investor has a fear that rising interest rates will lead to a raging bear in the stock market resulting in them losing the gains they’ve enjoyed since the election of President Trump. The question is whether these fears or real or just a constant drumbeat from the “perma-bears” who seem to thrive on making money by selling pessimism. It has been a long time since we’ve even seen rising rates so this becomes a critical question for investors.
There are some important things to know about the market that are so simple yet profound. First, stock prices follow earnings …. period. In the long-run, stock prices have always and will always follow the underlying earnings of the companies involved. That is the fundamental difference between stocks and say, commodities that have no underlying earnings.
When you buy a share of stock, you are entitled to a pro-rata share of that company’s earnings so you’re buying a tangible forward stream of income. That is the foundation of Warren Buffet or Benjamin Grahams successful value investing: can you buy a sustainable and growing forward cash flow for a value today that will be recognized by others later down the road.
The second important thing to remember is that competition for return in the market is significant. In other words, investors always seek the highest return (just as water always seeks the lowest point). It’s a standard cliché but a true one. Therefore, when interest rates are low or declining as they have been since 1984, money tends to flow into stocks where earnings yields (the inverse of a Price/Earnings ratio) are superior.
For example, in today’s market the yield for a 10-year bond is around 3 percent. So you tie up your funds for 10 years and you earn 3 percent. Granted, that’s a risk-free yield as your virtually certain to get your money back. Today’s stock market is valued however at around 20x earnings, or an earnings yield of 5 percent. The average dividend is about 1.9 percent so when you add the earnings yield of 5 percent to the dividend of 1.9 percent, you have an expected return from stocks of 6.9 percent. Compared to the 10-year bond, this is very attractive.
There are future issues to consider. These include the growth in earnings and the expected rise in interest rates. There is no crystal ball but, by far, the consensus is positive for company’s earnings over the next 12 months.
The tax cuts and regulatory relief provided by the Trump administration have been very positive for the economic situation of the U.S. With growth however comes the possibility of inflation which translates into rising interest rates. On this, the strong consensus is that, yes, rates will likely rise but they will rise slowly because inflation is not rearing its ugly head.
The bottom line, assuming no significant shocks to the system which no one can predict, it looks like the markets will be rewarding stocks for 2018 and possibly 2019. Look for 3,100 on the S&P 500.
Steve Beaman is the Chairman of The McGraw Council and the author of The Path to Prosperity.