There remains so much fear today, mostly because of the deep recession of five years ago, but due to fearful macroeconomic headlines. Fear results in no confidence, two opposite ends of the spectrum, and often leads to panic, just as overconfidence can lead to euphoria. When these emotions are applied to investment markets, bear and bull markets occur, occasionally leading to steep declines or bubbles.
Throughout each cycle there always is significant noise, but investors must learn to distinguish the signals from this universe of noisy data. On a single day, modern society generates more information than all of civilization had created before 2003. Noise increases faster than the signals; we think we want more information when what we really want is knowledge, wisdom and an original thought process leading to successful results.
The true signals in the investment world are found in the three most important considerations: inflation, interest rates, and corporate profits. The stock market and the economy are cousins; they are not twins.
Interest rates
Over the past two years, there have been over 400 stimulative initiatives in an expanding global economic cycle as countries and central banks reduced interest rates.
Now, rising interest rates eventually may create competition in the demand for stocks. Many today are focused on the Federal Reserve monetary policy of quantitative easing.
Investors need to know that by the time shifts in policy officially occur the marketplace already will have sent the signal. Ten year treasuries have risen from 1.5 percent to 2.6 percent, and mortgage rates are up by a third over the past year.
Currently, the level of rates is not enough to compete with the attraction of equities. In 2004, the last time rates began an upward climb, Fed funds were 1 percent versus 2.5 percent now, and the Fed raised rates 17 times through 2006, while the S&P 500 rose 11.3 percent, and the Russell 2000 rose 22.5 percent. The S&P 500 almost doubled during 2009-2010 in the face of increasing bond yields.
Housing demand is heavily influenced by the level of interest rates. Mortgage rates are not likely to negatively impact housing until they enter the 5.5-6 percent range.
Currently, rising mortgage rates appear to be encouraging fence-sitters to buy. Stronger housing is essential for both confidence and employment and must be considered one of the pillars of a strong stock market. Increasing bond yields are a positive for stocks up to a point and indicate an improving economy. Declining bond prices are encouraging investors to buy stocks, but thus far investors only seem to be moving a small portion of their cash to equities. Eventually, if investors begin to lose money in bonds, we believe the rotation to equities from fixed income will begin.
Inflation
If rates rise enough to indicate a substantial increase in inflation, that would be a signal for concern. An increase in the cost of living may indicate solid economic growth, improving employment, and capital and consumer spending increasing due to an upturn in confidence in the economy; however, if inflation is a result of too much demand and too few goods, and interest rates spike upward to slow demand, this development surely would be a sign for concern.
Corporate profits
Corporations deserve significant credit for the improving economy and rising stock market the past few years, in my opinion. Monetary policy has been instrumental in driving rates downward and spurring an increase in demand, while corporate management teams have maintained fortress balance sheets and increased profit margins through intelligent pricing power and cost control.
Earnings per share have averaged 5.3 percent growth over the last six decades. Profit margins are at record highs today, and free cash flow is being utilized to buy back stock, for mergers and acquisitions, dividend increases, and reduction of debt. If such profitability declines, any and all of these activities likely fall as well. Price earnings ratios as a clear valuation measurement may also compress. Healthy stock markets typically reflect rising earnings and rising multiples upon those earnings. Any reversal of this pattern may serve as an indicator.
When considering investments it’s best to focus on interest rates, inflation, and corporate profits.
These are the differentiators between long-term economic events and short-term market events. It is the individual company, not the economy, the markets, nor the stock that is most important. A stock can only do as well as the company itself, and behind every stock lies a tangible, operating business.
Jim Hansberger is managing director-wealth management, Hansberger & Merlin at Morgan Stanley in Atlanta
