Taking a Harder Look at Valuations as Interest Rates Rise
In 1949, notable economist Ludwig von Mises published the first English version of his masterpiece Human Action. In this pivotal work on economics - and somewhat of a defense of capitalism – Mises examined themes such as the way individuals’ decision making impacts economies and markets. In the work, he asserts, “The market is not a place, a thing, or a collective entity. The market is a process, actuated by the interplay of actions of various individuals cooperating under the division of labor.” This concept seems apropos during our recent period of increased volatility, especially after such a significant period of record low volatility.
Will investors be indifferent to even positive earnings results, potentially leading to lower valuations?
At times, it is difficult to not think of the market as some detached entity where mystical forces drive prices in unexplainable ways. However, Mises reminds us that prices are truly driven by each individual participant’s assessment of value at any given moment. However, as a process, price discovery is not stagnant but instead is always in flux. In this process of price discovery, information is the key input for participants to determine their eagerness to buy or sell at any moment. This fact is important when we are tempted to think about common colloquialisms such as “overvalued,” “frothy,” or even “correction.” If markets were truly “expensive” a rational investor would not continue to buy and would likely sell their holdings at those inflated prices. So why do we get volatility? Why aren’t prices stable? As a process, price discovery relies on the combination of ever-changing information and assumptions, but more importantly, as Mises states, “(on the) definitive choices of the members of the market society,” – nothing more.
As they navigated the volatility of the first quarter, investors had their memories refreshed that assumptions and inputs matter. Factors such as rising interest rates impact discount rates used to value stocks. Changes in global trade norms and tax rates impact corporate earnings. Investors, who entered the year with a rather euphoric world view, quickly reassessed their assumptions when new data and uncertainty entered into the process. Stocks that once looked reasonable were judged to be worth not quite as much as they were at the end of January.
In the short term, investors are focused on corporate earnings results. The changes in tax rates and expectations of continued economic prosperity have set consensus expectations exceptionally high. In fact, the leading data provider, Factset, anticipates a 17.3% increase in earnings growth in the first quarter. If this comes to fruition, year-over-year earnings growth will be the highest since the first quarter of 2011.
If earnings don’t turn out to be as impressive as anticipated, investors will likely be eager to sell those companies that miss the mark. Strong earnings expectations have been one of the main justifications for the recently lower price to-earnings valuations. While stocks do not appear as expensive as they were at the end of last year, strong earnings growth needs to occur to support the market. Beyond simple earnings results, market participants will also need to see validation of operating results and a continued positive outlook. How companies get to the bottom line will matter.
The Tax Cuts and Jobs Act of 2017 is likely to benefit the bottom lines of most companies in the first quarter as the corporate tax rate dropped to 21% from 35%; however, this is the baseline expectation. As with every reporting season, what is important is verification of how a company is growing, and whether that growth validates analyst assumptions. Expectations for future growth are what drive current valuations, and the market does not like uncertainty.
How companies will choose to use the money they will save from lower tax rates – whether employee bonuses or raises or reinvestment in R&D -- remains to be seen. Management’s guidance on the matter will help to illuminate a company’s potential for future corporate success. Other than the new tax rates, how cash repatriated from foreign countries is to be deployed – share repurchases, dividend increases or other uses -- is being discussed the most.
That said, the price/earnings ratio for the Standard & Poor’s 500 Index has returned to more of a normal range than it was in earlier this year. At the end of the fourth quarter, the 12-month forward p/e ratio was around 16.4x, compared with a recent high that was just shy of 19.0x. The return to the more normal range has been driven by the assumption of higher earnings (denominator) and lower prices after the correction (numerator).
As market participants assess the value of potential investments, we are seeing a shift in inputs that have remained fairly stable for the past decade. While we discussed financial engineering at the corporate level, many critics have pointed at the Fed’s policy of artificially keeping rates low and thus stock valuations high.
In the most basic form, a company is worth the net present value of its future cash flows. With interest rates hovering around zero since the financial crisis, the discount rate has stayed consistently low. However, as rates rise, and perhaps by way of an unexpected bump in inflation, analysts are now forced to consider the impact to valuations if those discount rates increase sharply. Will earnings growth be enough to offset the downward pricing pressure of a higher discount rate?
As we have mentioned, despite expectations of strong earnings growth this year, there is a distinct risk that it will not satisfy the market. The anticipated impact of the tax cuts and strong economic growth have set the bar high. While we are likely to see significant growth, investors may find themselves disappointed in the event of a “ho-hum” reaction from the market. Then the question becomes “How sustainable is the stock rally after the ‘sugar high’ of tax cut effects wears off?” That may not be a problem in the second or third quarters, but it makes market direction more difficult to predict for later in the year. A theme in the near term may be that equities have more limited upside on the back of strong earnings reports than they do significant downside potential if earnings end up being less robust than expected.
The earnings litmus test is really going to be what happens if topline growth fails to materialize? If the robust growth in sales does not continue, anything can happen in the second half of 2018. The personal savings rate hit a 10-year low of 2.9 percent in July 2017 before climbing slightly to 3.3 percent in February and continuing to rise since then. If consumers choose to save rather than spend their tax refunds, it will be bad news for stocks because it will put a damper on consumption and earnings.
While new tax rates should be a major boost to earnings, there are some potential headwinds. Factset noted that a weaker dollar accounted for nearly 60 percent of earnings growth in 2017. How the U.S. dollar performs compared with other currencies will will also affect earnings in 2018. Energy prices will be another key factor in earnings.
Currencies will also be an important factor in performance in the international space. Foreign stocks, especially in emerging markets, may continue to be the leaders in 2018, but perhaps to a lesser degree than in 2017. The primary risk for not only emerging market stocks but all international stocks is the added complication of currency fluctuations, which could adversely affect returns in subsequent quarters. Latin America as a whole has demonstrated its ability to surmount difficult struggles and perform fairly well in 2017 and so far this year. However, if the dollar gains strength versus local currencies, stocks in those countries could still produce negative returns for U.S. investors.
In a market environment of increased volatility and one where results matter, active management of equity investments should outperform. In the near-zero interest rate environment, the low discount rate has minimized the importance of differentiated earnings results. This has resulted in an environment where correlations were high and a “rising tide has lifted all ships.” Now, we are seeing a distinct decrease in correlations as corporate results increase in importance.
Rising interest rates also impact operating results. As cheap debt has benefited the highly levered, those same highly levered companies are facing incrementally higher costs of debt. As those advantages dissipate amid rising interest rates, whether in the short or long term, it is likely to expose weakness in the balance sheets of numerous companies and result in lower valuations. More attention needs to be paid to the possibility of some companies becoming insolvent if they are not able to keep up with their debt obligations. That consideration should take into account the potential for significantly higher rates (if inflation starts to get out of control), quicker rate hikes, and how each of those scenarios could affect economic growth.
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