Thursday, October 13, 2005

The Current State of the US Equity Market

Three things drive equity market returns: Earnings, interest rates, and risk.

When I refer to earnings I mean economic earnings, or what Buffet calls “Owner’s Earnings,” which is the cash flow left over after paying all obligations including the cost to replace the capital equipment used to generate those earnings. GAAP earnings are often illusory.

Interest rates impact the market because they influence the discount rate that an equity investor will use to calculate the present value of his expected earnings. Equity investors use a discount rate that is acceptable to compensate them for investing in risky assets like stocks. As rates on risk-free Treasuries rise, so will the discount rate because the risk-free rate is an opportunity cost. Likewise, the discount rate will increase when risk increases. As the discount rate rises, the present value of a stock’s earnings decreases and the price an investor will pay for equities declines.

Well, the market has not done well lately and it’s not because earnings have been disappointing. In general, earnings have been pretty good and growing. In fact, some of the most beat up industries like home building have reported or are expected to report continued double-digit growth in earnings compared with this time last year. So, that leaves interest rates and risk as the culprits.

The stock market has been beaten up recently because of inflation fears. Those fears have been fanned by the many remarks by employees of the Federal Reserve Bank over the past two weeks. Inflation, if it ever shows up, will force long bond prices down and interest rates up. So far, though, inflation is not showing up outside of energy prices. Yes, the PCE deflator, which the Fed closely follows, has risen to the top of the Fed’s “comfort range,” but the top of its comfort range is two percent; not a rate that gets too many people overly excited.

In fact, long bond investors have been so comforted by the Fed’s paranoia about inflation that they have bid long bond prices up and lowered long-term rates; the ten-year treasury is trading at 4.47% today and it was 4.60% over six months ago. It even fell below 4% recently. Ostensibly, long bond investors think that inflation is under control and I agree with them.

As for energy prices, we’ll adapt as long as we are free to pursue alternatives. We adapted after the OPEC shocks of the 1970s by drilling in the North Sea, Mexico and Venezuela and building a pipeline in Alaska. We’ll adapt today by finally drawing from the second biggest deposit of fossil fuels in the world in western Canada. And, maybe the Kyoto Krazies will back off and make it easier for Anwar to be developed when they realize that their Priuses still cost a lot to fill when gas is $4 a gallon.

The perceived risk, however, has increased. Volatility in equity prices has risen in the past month after being exceptionally low for most of the past year. If equity volatility has risen because of the comments coming from the Fed about inflation as I suspect, and that inflation does not materialize, I expect a large market rally. Rates will not go up as currently feared, and the perceived risk will decline. Earnings are not the problem.


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