RateWatch #408 – Equities

May 22, 2004 by Dick Lepre
dicklepre@rpm-mortgage.com

What's Happening

This week, one Fed member said that rates will be increased at "a measured pace" noting, "The pace of tightening will, of necessity, respond to evolving economic conditions, particularly the strength of the ongoing recovery in the labor market and developments on the inflation front." In plain English: the Fed will start increasing soon but will keep rates low if inflation remains in check. The priorities are: 1) GDP growth and 2) jobs.  Concern about the effect of Fed hikes on the
economy is overblown.  Talk has certainly hurt mortgage rates but once folks realize that rates are not going to soar then perhaps anxiety will subside.  This relief from the upward pressure of the secular bear market is not likely to occur for six months.

Equities

This past Monday I was listening to one of those discussions on a cable news channel. They were discussing the stock market and inflation and I was began to think, "either these guys are nuts or I am."  What they were saying was that the equity sell-off that had been going on for a few days was an indication that the stock market had peaked and that we were in for an extended period (as in "years not months") of a lower or at least stagnant Dow.

If the proposition is that higher interest rates will lead to lower corporate profits and an extended period of stagnation for equities that thesis is inchoate. To be sure, higher rates cost companies money and lead to somewhat lower profits but the picture is much larger than that.  When all the BS is stripped away, equity values are more about P/E ratios than anything else. And if earnings go up and P/E stays flat then the price will go up. Corporate profits are driven by much more than
interest rates. 

To a large extent, business has borrowed money at low cost in the 1st Q and is ready to deploy it.  This should result in GDP growth.  Offshoring, even if does not result in the exportation of a significant number of jobs serves as a hammer for labor cost containment and that should help corporate profits and equities.

In short, I see no gloom for corporate profits even if the Fed rates go up a couple of percent.  Running with money borrowed at low rates for expansion and almost zero pressure of wage inflation the environment is healthy for business.

Why are stocks worth what they are worth?  Stocks are sold in an open market.  Stock prices rise because there are more buyers than sellers.  Stock prices fall because there are more sellers than buyers.

In the "old" economy stock prices reacted to news that was perceived to affect earnings.  A few years ago we started to talk about the "new economy."  In essence that was a scam devised to convince folks that the IPO's of dot-com's had value that had to be computed with a new model.

Let' take a step back.  What is the purpose of the stock market? To my simple mind it has only two purposes.  1) When a company wants to make a public offering (either an IPO or a secondary offering) the stock market is where this happens.  The companies get the capital. People buy shares of stock and own a part of the company and are thus entitled to a share of the future profits.  2) The market provides an instant way for shareholders to sell their stock.  This makes stock extremely liquid and increases the value of the shares somewhat.

The IPO boom of the dot-com era was not driven by common sense. Many of these companies had no real plan as to how to deploy the capital in a profitable business model.  Instead, the
intent was to make the founders rich, let Wall Street take a cut, and feed the greed of non-investor equity buyers. Hopefully, a lesson was learned and equity buyers are smarter.  The Google IPO, while perhaps unique, seems to be discouraging the practices of the ‘90’s. 

We have come out of a modest recession in 2001 and, of late, have experienced healthy GDP growth.  Jobs, always the last thing to come on line in recoveries are doing quite well. I do not see any reason to dump equities.

In addition, we are slowly becoming inured to the effects of terrorism.  It may be the case that in the future, horrifying events do not cause the post-9/11 equity shock that we saw in 2001.  Not exactly a happy thought but perhaps one with a measure of truth.

To receive this free RateWatch newsletter each week by e-mail, click here.
To view the archive of past RateWatch newsletters, click here.