Money Sage (archive)

As we contemplate prospects for the American equity market, it occurs to us that it might be useful to present our "catalogue of stock market magic."
In our view, there are three types of "magic" related to stock price appreciation. Two of these we deem "true magic." The third we adjudge "phony magic."
The two authentic types of "magic" are not really magic, of course. What they are is legitimate generators of gains in stock prices. There are two varieties:
(1)Earnings growth;
(2)Multiple expansion.
The false source of gains in stock prices is: mania arising from herd stampede.

In examining the history of stock prices it readily becomes clear that certain stocks have racked up immense gains over a multi-year period because of impressive earnings growth. At some point in the growth cycle, the inception of dividend payments occurs. Generally -- though not always -- dividend payouts grow over the course of time. This bolsters further the value of the stock, and underpins the long-term growth in price.

This type of growth-driven long-term rise in the price of a particular equity is the most reliable source of enduring gains. Price does inevitably follow value, though the time lags can be long, and the intervening volatility quite discombobulating. Still, in the end, price reflects value. In the case of stocks, value equates to the theoretical total of all future dividend payouts. In practice, value equates to future earnings achievements. It is useful to bear in mind that during periods of stock market volatility, and in outright bear markets, stocks with a reliable dividend payout will exhibit considerable resistance to excessive underpricing; dividends have an important value in real time that future, anticipated earnings streams do not.

The second variety, which we wish to focus on here -- mulitple expansion -- is significant in a number of contexts:
--during rising markets;
--during periods of falling interest rates;
--subsequent to periods of unpopularity and attendant multiple compression.
We should note here that the overall market itself experiences cycles of price/earnings ratio expansion and cycles of multiple compression. A major force bearing upon the onset, duration, and culmination of these cycles is the interest rate cycle. Plainly put, as rates decline interest bearing investments decline in attractiveness relative to equities; an increasing volume of liquidity moves into stocks, driving prices up within the context of stable earnings, or, when earnings are growing, by a much greater percentage than the percentage gain in share profits. Dividend payouts become increasingly attractive RELATIVE to DECLINING interest yields on debt securities. Additionally, equities have the added attraction of promising future growth in the payout stream.

As far as popularity is concerned, the equation is very clear. Individual equities and stock groups which fall from favor usually keep deteriorating in attractiveness, even when earnings are stable or even rising. Price falls because the amount of money per dollar of earnings or per dollar of dividends that the investing public and the investing institutions are willing to pay contracts in tandem with their sinking popularity. At some point in time, the trend reverses. The pendulum swing typically -- though not always -- carries the multiples of previously unpopular stocks from abnormally low levels back to "normal valuations" and then to overvaluation. The pendulum moves to a substantial degree in response to herd psychology. Accretions to popularity accelerate as prices rise and the security becomes increasingly overvalued. Consequently, pendulum movement reflects reasonable value for only a brief period of time.

Multiple expansion lacks the fundamental basis of price appreciation built upon solid earnings growth. Nevertheless, it is a very important factor in determining price gains, especially over the short-intermediate term.

As far as the "magic" of price gains based upon that which we have defined as false -- the stampeding of the herd which creates manias -- this produces the largest gains in the short-intermediate period. However, these gains are the least reliable. When the inevitable pendulum reversal occurs, the consequences are frequently catastrophic.

In today's market, the most obvious potential source of price gains inheres in the probability of multiple expansion. The interest rate cycle is clearly in the down phase, as referenced both by market rates and by the FED-controlled overnight rate. Our view is that the enormous household debt overhang, in the context of the deepening bear market in house prices and the derivative credit market contraction implies a VERY SIGNIFICANT FURTHER DECLINE IN INTEREST RATES. We have cited the contractionary and deflationary implications of the current situation on a number of occasions. In this context we would note that the back of the last expansion was broken by a 6% FED funds rate. Once the recession set in -- and it was a very, very mild recession by historical standards -- the FED found it imperative to take the overnight rate down to 1%. The 10-year note declined to 3%, the 30-year bond to 4%.
This time around, the FED raised the funds rate to 5.25%. This level clearly catalyzed the economic (fill in the blank) which now looms before us. While the previous up-cycle in rates popped the stock market bubble, the most recent upcycle popped the residential real estate bubble. Moreover, between the 6% funds rate in 2000, and the 5.25% rate in 2007, there was a great deal of ADDITIONAL HOUSEHOLD DEBT accumulated. In other words, the FED was able to stop 75 basis points lower to inflict the same amount of pain (or, much more, we have yet to see) on the generality of American households given the substantially greater amount of debt and the attendant deterioration of household balance sheets.

The way we see it, a bear market in house prices is far more likely to damage consumer spending than a bear market in stocks. For the great bulk of Americans, their house is their principal asset. (Frequently, it is their only asset). A persistent bear market in house prices and deepening illiquidity in the real estate market have the opposite of the "wealth effect" of rising house prices. Consumers/homeowners become frightened and curtail their spending. Additionally, many consumers have financed discretionary spending via repeated house refinancings and home equity loans. These crutches are increasingly unavailable. So, in addition to the perception of declining wealth and the fear generated by rising monthly mortgage payments and rising defaults and foreclosures, more and more consumers confront decreasing ability to access home equity to finance consumer purchases.

In this context, one must wonder where the bottom for both FED FUNDS and market rates is likely to be. It is a certainty that the smaller the FED rate cuts, and the smaller the liquidity increments the FED supplies to the banking system, the farther down rates must ultimately sink.

For stock investors, this promises significant multiple expansion. However, it is important to bear in mind that the prime beneficiaries of this multiple expansion will likely be stocks of those companies which are well insulated from the housing/banking/retail/consumer downturn. Moreover, the high level of fear in both the equity and credit markets, and the pervasive perception of forthcoming recession and the negative impact of same upon earnings, have thus far counteracted the normally beneficent consequences for stock prices of three successive FED rate cuts. We believe that the market is worried not only about recession and earnings declines, but by the increasingly transparent possibility of a very serious credit contraction in coming months.
The bottom line is that while the beneficent impact of lower interest rates on stock prices will likely occur, it may NOT occur without further stock market pain in the interim.

One key variable influencing the extent and speed of mulitple expansion in the equity market will be the actions -- or inaction -- of the Bush Administration. Critically important measures are needed to offload banks' bad loans so that their lendable capital will stop contracting and they will, in due course, be able to increase lending. Fiscal measures -- such as tax relief to mortage-payers or outright subsidies for resetting mortgages -- and not merely resetting sub-prime mortgages -- could reduce the need for drastic reductions in interest rates. The extensive employment of government loan guarantees for existing weak mortgages and for future mortgages would also be helpful. For stock investors, this would translate into multiple expansion and a rising stock market sooner rather than later. It would also likely reduce the extent of any further market correction.

As we have noted in earlier posts, the FED must restore bank lending to substantial profitability. It is not only that the banks do not wish to lend: they do not wish to borrow either. Spreads between short and long rates are, after all, too narrow to facilitate adequately profitable lending. The FED remains far, far behind the curve as we ink these words.