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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:
V = 100 * (E/I) * SQR[(R+G)/(I+F)]
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Where:
V = Stock Value in $/Share
E = Earnings Per Share in $/Share
I = AAA Corp. Bond Rate in Percent.
SQR = Square Root
ROTC = Return on Total Capital in Percent.
R = I * SQR(ROTC/I)
G = Annual earnings growth rate in %/yr.
F = CPI inflation rate in %/yr. |
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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:
E = 31.50 $/Share
I = 8.4 Percent
ROTC = 10.0 Percent
R = 9.2
G = 8.0 Percent/yr.
F = 2.9 Percent/yr. |
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Substituting these figures into the equation |
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Substituting these figures into the equation gives:
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V = 100*(31.50/8.4)*SQR[(9.2+8.0)/(8.4+2.9)]
= 100 * (3.75) * SQR(17.2/11.3)
= 100 * (3.75) * (1.23)
= 461.25 |
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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.
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