VectorVest: Stock Analysis and Portfolio Management System

"Astute investors know that three powerful forces drive the stock market. These forces are known to everyone, but are often misunderstood."

There's a terrific battle raging on Wall Street. The Bulls are looking for new market highs, and the Bears are saying the party's over. Both camps are making their point with a plethora of facts, fiction and fluff. How can we cut through the flak and focus on what's really going to happen?

Astute investors know that three powerful forces drive the stock market. These forces are known to everyone, but often misunderstood. They are related, but independent. They are measurable, but controversial. They convey the effects of all that happens, and ultimately determine the fate of the market.

When a major event such as a product introduction, an earthquake, or assassination occurs, investors instinctively speculate on whether the event will help or hurt the stocks they own. If the event seems likely to help earnings, prices rise. Conversely, prices fall if the news is perceived to be harmful. Corporate earnings is the first powerful force driving the stock market.

The bug-a-boo of a strong economy, and the thing that's currently haunting the market is inflation. Inflation, of course, causes raw material, labor and service costs to increase. Unless a company increases productivity and raises prices, profit margins narrow and earnings go down. Rising inflation rates ultimately push stock prices down. Inflation is the second powerful force driving the stock market.

Inflation not only lessens the value of financial assets, it erodes the purchasing power of consumers. Left unchecked, inflation destroys monetary stability, and leads to a weak economy. The Federal Reserve Board (The Fed) is charged with the responsibility of maintaining monetary stability. It fulfills this task by controlling the money supply. When The Fed sees inflation increasing, it tightens the money supply, and interest rates go up.

Ironically, higher interest rates raise costs. It stifles investment, weakens the economy, hurts corporate earnings, and eventually leads to a Bear market. The third and perhaps most powerful force driving the stock market is interest rates.

In Summary:
Stock prices rise when earnings go up. Stock prices fall when inflation rises, and stock prices fall when interest rates increase.

While most investors are familiar with these basic observations, the stock valuation formula published in last month's Investors Alliance News is the only relationship which ties them together. Here it is:

The equation clearly shows that Stock Value increases when Earnings Per Share, Profitability, and Earnings Growth Rate go up. Stock Value decreases when Interest rate and CPI inflation go up. Let's see how Eq. (1) can help us understand why and how the market cycles.

First, let's calculate the Value of the S&P 500 stock index to see where it stands today. As of September 23, 1994 , the following data was available on the S&P 500:

Substituting these figures into the equation gives:

The S&P 500 closed at 459.68 on September 23, 1994.

The equation is saying that the S&P 500 is fairly valued. The race between higher earnings and higher interest and inflation rates is even. Neither Bull nor Bear currently has the upper hand.

Bull markets are born when the economy is very weak. Consider the most recent cycle. The Bull market began in October, 1990 when the economic outlook was dismal and earnings were falling. That may sound absurd, but one must remember that interest and inflation rates were also falling.

The power of lower interest rates can be illustrated by noting that the S&P 500 index would rise 79 points (about 17 percent) if the AAA Corporate Bond rate fell only 1.00 percentage point. Obviously, when both interest and inflation rates were going down the market had extraordinary lifting power. This is exactly what happened in late 1990 and throughout 1991. It was the interest sensitive phase of the Bull market. Stocks of financial companies soared.

The economy began improving in March 1991, and earnings began to rise. Inflation and interest rates continued to fall, and the Bull market was in full swing. Stocks in housing, furniture, appliance, and other associated industries were on fire. It was the best of all worlds.

The Fed's last major move to lower interest rates was made in December 1991. The economy and the Bull market rolled on. Cyclical stocks such as autos and producers of large capital equipment were in vogue.

But things began to change with the subtle rise in interest rates in September 1993. The investment climate turned cloudy when The Fed tightened monetary policy in February 1994.We are now in a classic final phase of this Bull market. Stocks of commodities such as steels, paper and basic chemicals are on the rise. They are the last groups to see the boom in earnings. But the deadly duo of rising inflation and interest rates are also taking their toll.

Investors are torn between betting on the Bulls or going with the Bears. The game isn't over yet, but the economy will eventually defeat itself. The better the economy gets, the more it will force the Fed to raise interest rates. The Bull market will continue until stocks become grossly overvalued, and high interest rates strangle economic growth. Then the Bear market will come, and the cycle will begin anew.