Low Rates, High Stock Prices: It's Not Just A PhaseJeffrey M. Laderman
Watch the Dow Jones industrial average racing along north of 5000. See the Standard & Poor's 500-stock index cut through the 600s. Catch the NASDAQ Composite with its extra digit, now that it's over 1000. Get used to the numbers: It's the stock market's new math.
The math may be new, but the fundamentals are old and familiar: corporate earnings and interest rates. In that light, the stock market's amazing performance in 1995 is easy to explain. Profits proved surprisingly strong, up about 18% on the S&P 500. Most pundits expected more modest earnings gains. But what no one had predicted a year ago was the spectacular drop in long-term interest rates that slashed the yield on the benchmark 30-year U.S. Treasury bond from more than 8% to today's 6%. The confluence of events could wind up making 1995 the best year for equities in 20 years, and the second-best in nearly 40 years.
No stock market can sustain that kind of performance for two years, so the prognosis for 1996 is more muted. More important, the fundamentals aren't in place for anything so dramatic. The U.S. economy will be sluggish in 1996, with gross domestic product growing at about 2%.
That means corporations will be hard pressed to generate the big bottom-line increases they achieved in 1994 and 1995. Operating profits won't fall off a cliff, but they could well come in around 6.5%--the long-term average for profit growth. Assuming no change in interest rates, that would send the market up 6.5%. Add to that a 2.5% dividend, and you come up with a 9% total return.
Suppose investors begin to realize that the decline in rates isn't just a knee-jerk reaction to a slowing economy. Instead, what if they come to the conclusion that low rates are here to stay? This means that the investment climate has made a once-in-decades shift that uproots many of the commonly held assumptions about investing. "People who think stocks are too high are using standards set when we had double-digit interest rates," says Edward M. Kerschner, chairman of the investment policy committee at PaineWebber Inc.
STILL UNDERVALUED? The new era of low rates and lofty stock prices is based on solid economic fundamentals. Inflation, while not eradicated, has been tamed because the U.S. government--and the governments of nearly all major industrial nations as well--are trying to get their fiscal policies under control. Inflation remains in check, too, because of increasing global competition that forces corporations to become leaner and more productive and figure out ways to make money other than by hiking prices.
The impact of interest rates on stocks is enormous. In fact, as far as stocks have come in the last year--1350 points on the Dow, 160 on the S&P 500--many analysts believe the stock market is still undervalued relative to bond yields. How much? Just look at the curve in the chart that relates interest rates to price-earnings ratios, as calculated by Kerschner. When 10-year U.S. government bonds yield 7%, the S&P 500 should have a p-e of only 13. If it were lower, stocks would be cheap; higher than 13, expensive.
Interest rates and p-e ratios are inversely related. When rates go up, p-e ratios go down and vice-versa. Drop the yield from 7% to 6%, and the p-e balloons from 13 to 18. Go down just a quarter of a percentage point more, to 5.75%--the current 10-year yield--and the p-e jumps to 20. Depending on your 1996 earnings assumption, the estimates of the p-e run from 14 to 18. So while investors might argue about how undervalued stocks are, the point is that equities are still cheap. "The more interest rates come down, the more bullish I become," says market analyst Elaine M. Garzarelli of Garzarelli Capital Inc. Her forecast for yearend 1996 is especially upbeat: 6300 on the Dow, and 740 on the S&P 500.
Of course, theoretical valuation models are not ironclad guarantees. They are just useful guideposts for investors. And undervalued stocks and markets can always become more undervalued, too. After all, the stock market hasn't had more than a 3.3% pullback in the 1995 rally, nor has it undergone a correction of 10% or more since 1990. "Even in a bull market, you can get a 10%-to-15% correction at any time," says Van Harissis, a portfolio manager for Phoenix Duff & Phelps. "I'd say we're long overdue."
GO FOR GROWTH. If and when that pullback comes, the stock market's new math will make it seem scary. But remember, with the Dow over 5000, 100 points is a move of less 2%. And all it would take to send the Dow down 100 is an average loss of a little more than one point in each of the 30 Dow stocks. But so long as the inflation and interest-rate backdrops remain favorable, smart investors should take advantage of sell-offs and add to their holdings.
The best investments in a slow-growth economy are "growth stocks"--the shares of companies whose earnings growth is reliable, steady, and much faster than that of the stock market in general. Most of the rip-roaring high-tech companies fall in this category. So are many big consumer goods companies, including Coca-Cola, Eastman Kodak, Gillette, and Procter & Gamble. Even though growth is slow at home, these giants have bright prospects because of their ability to sell overseas.
"People worldwide genuflect at the altar of brand-name products," says analyst Brenda Lee Landry of Morgan Stanley & Co. As consumers' incomes rise in the economically emerging nations, she says, they typically buy the products these companies sell. "The fundamentals for these companies look the best they have since the early 1970s."
While most of the big global growth stocks have moved up, they're still worth buying. For instance, Phillip H. Brown II, president of Meridian Investment Co. recently bought Procter & Gamble Co. The reason: the p-e based on 1996 earnings is about the same as the S&P's, but he thinks P&G earnings gains will be about twice that of the market. The market is asking no premium now for P&G's superior earnings growth.
But in a slow-growth, low-inflation world, investors will eventually pay that premium. That's when growth stocks really pay off. Look at what happens to p-e ratios of growth stocks under various scenarios (table). PaineWebber's Kerschner, who prepared this analysis, is working on the assumption that the market's long-term earnings growth rate is 6.5% and the p-e based on 1996 earnings is 17.5. Under such assumptions, a company with a steady long-term growth rate of 10%, like P&G, could justify trading at 22 times earnings--a p-e 26% greater than the S&P 500's. Suppose the S&P p-e moves up to 20. P&G's p-e could go to 26.
With faster-growing companies such as Wal-Mart Stores, with a 15% growth rate, or Home Depot, with 20%, the p-e ratios could expand even more. That's because with low inflation, the future earnings those companies will generate are worth much more in today's dollars. A company with a solid 15% long-term growth prospects rate could command a p-e of 31 and one with 20% growth a p-e of 43.
Lofty valuations, for sure. But if the investor-friendly environment of low inflation and low interest rates stays in place, these high p-e ratios will become part of the stock market's new math.