When interest rates decline, P/E multiples increase; conversely, when rates rise, multiples contract...
When interest rates decline, P/E multiples increase; conversely, when rates rise, multiples contract. This is a simple mathematical axiom of financial analysis and stock valuation and is at the heart of the investment issues facing equity portfolio managers today.
With rates at historically low levels, if the US economy rebounds to the current forecast levels of 2.5% and 3.5% annualised GDP growth for the upcoming second and third quarters respectively, rates will rise and P/E multiples will contract.
This axiom has already manifested itself in the past few months. The technology sector has rebounded aggressively since last October because it contains a host of companies with tremendous operating leverage to an upswing in domestic capital expenditures, little to no debt and an abundance of cash.
Put another way, this was the first place to look for 20%, 30%, and 40% long-term earnings growth to offset rising rates in the event of an economic rebound. Add to this group such select companies as Ebay, Amazon and Yahoo!. These firms are generating tremendous growth regardless of the outlook for the global economy, which explains the investor interest and the premium at which they currently trade to the S&P 500.
We have also recently witnessed the downside of the stock valuation axiom. The Fed lowered the discount rate in June to 1.25% for what may be the last time. But instead of the 10-year note following it down, it rose to more than 4% and the yield curve became steeper for the first time in two years. This meant that bonds and stocks disconnected and both declined.
If the required rate of return on financial instruments is raised, P/E multiples will contract and stocks and bonds will go down together. There are many bond investors that would like to believe the 10-year note will remain in the 4% range for the foreseeable future. If there is any basis to the economic rebound being forecast, that would seem unlikely.
This is the bear and bull case in a nutshell. It is uncertain how stocks can climb any higher. They will only be able to do so through significant earnings surprise on the upside.
Current earnings estimates for the S&P 500 are for $52 vs $48 for 2000, an 8% gain and probably a little lofty, especially in light of stricter accounting practices being adopted. For 2004, estimates are for $58, another 8% gain, but well below peak earnings of $61 in 2001. In our view, the earnings outlook for 2004 needs to improve for this market to continue rising.
Where will this earnings growth come from? Clearly, the monetary and fiscal stimulus in the US economy is present but there is more to it than that. The technology boom is real. Both corporate productivity and medical breakthroughs are moving to new highs and the opportunity to export this productivity is wholly underestimated.
Consumer spending and consumption habits are changing rapidly, creating a plethora of winners and losers in a new economy. The broadening of a global marketplace to include both China and, hopefully, a more productive Europe, is creating tremendous opportunities.
Strong fiscal and monetary stimulus.
Entrepreneurial global marketplace.
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