Saturday, May 17, 2014

Reframing an Old Picture

The macro narrative of the US stock market is weird. It has been on a tear higher since early 2009, recovering the losses seen during the 2008 crash, and continuing on to make new all-time highs. Meanwhile, the real economy is having a much harder time keeping up with the higher valuations. Mainly due to unemployment and to a certain extent underemployment, which is filtering through to low-to-no wage growth, the same for trends in consumer spending, and the same for GDP, and the same for inflation expectations, the list goes on.

How soon is still very fuzzy, but whenever interest rates start rising, the discounting approach to equity valuation would suggest a correction in stock prices, or at the very least a slowing of the rate that the securities appreciate. Especially when further increases in dividend payouts don’t seem very likely from this point. Companies have already paid out massive amounts of cash from earnings back to shareholders in the form of dividends and share buybacks, which have done nothing but support the run-up we’re seeing in stocks.

Low interest rates have been a good input for a valuation model that uses them as the denominator, perfectly suited for an economy emerging from a recession. But as the denominator in the model gets bigger, the output should get smaller. Stock prices going down flies in the face of intuition, so I suggest we simply just pick another way to prove that stocks should definitely be worth more over time. A method that better suits a rising interest rate environment.

The logic would be, if interest rates are rising the real economy should be growing [at least consumer prices should]. If the economy is growing coming out of a recession or a protracted period of slow growth, behavioral economics can kick into overdrive and propel equity prices higher as investors rationalize higher and higher multiples of earns in their forecasting and valuation models. That’s all good and well, but the real economy doesn’t have the convenience of swapping out one valuation method for another to outline the same growth narrative.

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