The Fundamentals of Stock Market Valuation

August 10, 2017

 

 

Last week there was a lot of hullabaloo in the financial press about the fact that the Dow Jones Industrial Average breached the 22,000 level.  We chose not to add to the amount of coverage in part because the Dow is a relatively meaningless index (the Dow measures the performance of 30 stocks – by comparison, the S&P 500 measures the performance of 500 stocks and is the most common benchmark for U.S. fund managers).  Moreover, focusing on a milestone like 22,000 is like having a huge bash for your 22nd birthday – some benchmarks are best marked quietly.

 

That being said, we think there’s still a lot missing from most recent stock market analyses in the press – the basic fundamentals of stock market economics.  Here are three basic tenets to keep in mind when looking at the recent performance of stocks.

 

Earnings

First, a review of basic stock market economics. As a group of investors, we make a deal with U.S. companies. We give them our hard-earned money as an investment in their common stock, and they give us a portion of their future earnings. The higher we expect those earnings to be, the more valuable the stock.

 

Suppose at some point in the past (for example, on November 15 of last year) we told you that despite recent disappointments, earnings for U.S. companies were forecasted to grow at a high rate in the future. A reasonable reaction might be … “there’s a lot of political instability right now, so prove it.” Further suppose that nine months later such growth in profits had occurred, and that growth was expected by analysts to continue. It’s reasonable to say … “hey, maybe stocks are worth more than we thought.” Obviously, that supposition isn’t hypothetical. Earnings for the past 12 months (ending June 30) were 20% higher than they were for the previous 12 months, and earnings for the next 12 months are expected to continue to grow by another 19%. We need to look no further for the cause of good stock market returns – high profits mean higher stock prices.

 

Interest Rates

Here’s another basic facet of stock market economics. The main competition for stocks as an investment vehicle is bonds. When interest rates on bonds are high, investors insist on a higher rate of return on their investments in common stocks – the way that higher return occurs is for stock prices to decline. That’s why stocks typically do poorly during large increases in rates (think the 1970s) and typically do well during interest rate declines (such as the mid-2000s).

 

In our last quarterly commentary, we pointed out that the recent sustained level of low interest rates was truly unprecedented. Combined with the projected growth in earnings, the low level of interest rates supports the high valuations of stocks, particularly if they’re likely to be permanent.

 

Currency

In general, the lower the level of the dollar, the better for U.S. businesses. That’s because a lower dollar means the price of U.S. goods is cheaper for residents of foreign countries, which is good for exports; and the price for foreign goods is more expensive for U.S. consumers, which is good for domestic sales. Since December, the U.S. dollar has declined against all major currencies by up to 10%.

 

Financial Press

Notice that we didn’t need to use any of the following words to explain why the stock market has performed well: policy, healthcare, taxes, or Trump. Many financial journalists have become politically obsessed, and the focus on politics perhaps has blinded many to the economic realities. We were discussing earnings increases last year – it’s only been in the past month that we’ve seen many in the press describe earnings as an explanation for market increases. Very few analysts in the press have called attention to low interest rates and the declining dollar as a reason for a healthy stock market. In many cases the financial press does a good job of synthesizing the news – in this case most reporters dropped the ball.

 

So … Why Not Invest More in Stocks?

We provided these explanations of why the stock market has done well and valuations are at an all-time high. But you shouldn’t blindly expect those high returns to continue, mainly because the prices to buy stocks ARE at an all-time high. There are many things that can go wrong – and when valuations are high, they can go wrong fast. For example, if in the next year earnings do not meet their lofty expectations, we would likely see a decline in stock prices. Such a decline could create a decline in investor confidence, which in turn could cause companies to reduce expenditures, which could cause a recession. This isn’t a forecast, but it’s a possibility – and one we always should be wary of.

 

There are other risk factors – global conflict is one that’s currently on many people’s mind.  Investing risks can be predictable, but often the larger risks are unpredictable.  For that reason, while we can justify the current high level of stock prices, we’re relatively neutral about the market going forward.

An audio version of this commentary is available here >>> 

 

 

 

 

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