Call it interest-rate shock. Mar. 8: A stunningly strong employment report triggers a massive sell-off in bonds, driving up the yield on the long-term U.S. government bond a quarter-point, to 6.71%, and dragging the Dow Jones industrials down 171 points. Mar. 11: Rates fall on the next trading day, and the Dow recoups 111. Mar. 12: Bonds sink anew, yields rise to 6.66%, and stocks swoon.
It wasn't supposed to be like this. Until a few weeks ago, investors operated on a scenario that the economy was in low gear, that inflation was dead in the water, and that corporate profits would show little growth. Stocks were to move ahead, because interest rates would remain under downward pressure--and it would be only a matter of time before the Federal Reserve Board slashed them further. Says Byron R. Wien, U.S. investment strategist for Morgan Stanley & Co.: "In just one day, all of the stock market's assumptions about 1996 were blown away."
NO BARGAIN. Now, the stock market is bouncing about as investors try to adjust to interest rates far higher than they imagined. That has caused a revaluation of stocks. The bull market is far from over, but it's also clear that stocks are not the bargain they were for most of the past year--or even a month ago. Indeed, some analysts say the stock market is fully valued now. But interest rates tell only part of the story, and they've been doing all the talking. Earnings count, too, and in a stronger economy, they could offset the drag of higher rates. But so far, investors can't seem to get their minds off of interest rates.
That's understandable. The 1900-point rise in the Dow that started 16 months ago was a product of falling interest rates. "Historically, you get the best stock market returns when interest rates are falling," says Melissa K. Brown, director of quantitative research at Prudential Securities Inc. "It's harder to make gains when rates are going up." During 1995, bonds were rising, interest rates were falling, and no matter how far the stocks in the Dow or the Standard & Poor's 500-stock index went, they remained cheap. That's because interest rates kept coming down and boosting what analysts call the "fair value" of the market.
Fair value is a theoretical price for stocks given a level of interest rates and corporate earnings. If rates fall but earnings remain the same, fair value rises, because the return on stocks becomes more attractive relative to what you can earn on an interest-bearing investment. Conversely, when interest rates rise, fair value falls as stocks become less attractive. Think of it this way, says Morgan Stanley's Wien: Fair value is the point of balance at which stocks and bonds are equally attractive investments.
So far, by most measures of fair value, the upturn in interest rates has not sent the stock market into the "overvalued" zone. But the rate rise is quickly closing the valuation gap, erasing equity investors' margin of comfort. "A few weeks ago, stocks were 19% undervalued relative to bonds," says Stanley Levine, director of quantitative research for First Call Corp. "Last week they were 9% undervalued, and now it's 6%." Morgan Stanley's fair value model also points to fuller valuations (table). Using a forecast of $40 per share in operating earnings for the companies in the S&P 500--the consensus of investment strategists' earnings estimates for 1996--and today's interest rate, the fair value for the S&P 500 is about 677. That's about 6% above current levels. Wien, for one, thinks earnings will weigh in at $41 and estimates the fair value at 691--about 8% higher than its current level. He's more bullish on the economy than most, and has been for some time.
Indeed, investors are coming around to an economy that's stronger than they thought. "The employment number shows the economy is no longer decelerating," says Kevin R. Parke, director of equity research at Massachusetts Financial Services Co., a mutual-fund company with $45 billion in assets under management. "But we don't think it's going to reaccelerate, either. It will go along in a flattish sort of way." Adds Philip N. Maisano, president of Evaluation Associates, a Norwalk (Conn).-based pension fund consultant and money manager: "You don't have the kind of income numbers to support a major [economic] growth spurt."
But even if the economy isn't going to step into high gear, interest rates are not likely to drop soon. "The Fed has to take these statistics at face value," says Paul W. Boltz, chief economist for mutual-fund giant T. Rowe Price Associates, which has $75 billion in assets under management. "It can't lower the fed funds rates now." Long-term rates could come down if bond investors start buying. But that's not going to happen soon. Investors will want to see a few more months of numbers to determine if the February numbers were a fluke or the real thing.
The bond crowd will also be watching to see if inflation kicks up. If it doesn't, bond prices should start to move up and rates come down. It was a fear of higher inflation that spooked the bond market in 1994--and its failure to show up got the bond rally going late that year.
But focusing solely on interest rates misses half the point, since earnings are the other side of the valuation equation. With a better economy, profits will be stronger. Edward M. Kerschner, chairman of the investment policy committee at PaineWebber Inc., was expecting lower, not higher rates this year. But he's not disappointed. He thinks the economy will avoid recession, and as a result earnings will be 10% higher than he expected--and that should offset the drag of higher rates. He still expects the Dow to reach a target price of 6100 in 1996.
GUIDEPOSTS. Just as it will take time to sort out the interest-rate picture, the earnings outlook could improve in a few months. Abby Joseph Cohen, co-chair of the investment policy committee at Goldman, Sachs & Co., uses multiple valuation measures that compare earnings, dividends, and corporate cash flows to a variety of long- and short-term interest rates and to the inflation rate. Most of these measures indicate stocks are fully valued based on 1996 earnings. But next month, Cohen adds, she will start to work up next year's profit forecasts, "and stocks will likely be undervalued based on those estimates." Hey, but that's 1997? No matter: The stock market always looks six to nine months ahead, and 1997 profits will be in investors' gunsights by summer.
Analysts warn that value guideposts are just that. Just because stocks reach fair value, they don't necessarily head south. Momentum and enthusiasm can keep stocks rising for a long time. Cohen says over the last 30 years, bull markets have peaked, on average, when they reached 15% to 18% above fair value. In 1987, the crash didn't come until after the market had hit 42% over fair value.
High as stock prices are, the indicators today suggest that stocks are a long way off from that kind of dangerous overvaluation.