The bull market in stocks has been supported by two fundamental pillars: high corporate earnings and low interest rates. Both of these mainstays appeared wobbly early this year. Fortunately for investors, there is now some good news for both of them.
Interest rates, which were expected to rise, have actually fallen since the beginning of the year. A series of statements by Federal Reserve officials - including a speech on Friday by Janet L Yellen, the Fed chairwoman, in Jackson Hole, Wyoming - now confirms that even if there are some short-term rate increases, the central bank expects relatively low rates to prevail for years.
Corporate earnings and cash flow, which had flagged, are stabilising and perhaps rising, according to a stream of corporate reports released during the quarterly earnings season, which is nearing its end.
Taken together, this information is hardly a guarantee that stocks will continue to rise or that current market levels will seem sensible years from now. But for investors, the interest rate and earnings environment has become friendly again, and without these buttresses, the outlook for stocks would be much gloomier.
Consider corporate earnings. They had been weakening steadily since the third quarter of 2014, as American companies ran into headwinds overseas and revenue softened. The strong dollar was an impediment, the global economy was sluggish, and plummeting energy and commodities prices sank the fortunes of companies in those industries. These trends unnerved the stock market.
But fresh data streaming in from corporate earnings reports has been good enough for Edward Yardeni, a veteran economist and market strategist, to declare emphatically in a note to clients on August 22 that "the earnings recession is over."
As he acknowledged, it's not entirely a rosy picture, and the numbers are complicated enough to make your head swim. On a year-to-year basis, for example, earnings in the second quarter are expected to have declined more than 2.2 per cent for companies in the S&P 500-stock index, according to a tally by Thomson Reuters I/B/E/S. That's hardly cause for rejoicing.
Exclude energy companies, however, and year-to-year earnings improved to a positive 2.3 per cent growth rate. Moreover, Mr Yardeni noted that compared with the previous quarter, overall earnings for companies in the S&P 500 increased in the second quarter. And while the consensus of Wall Street analysts is that the current quarter's earnings will post another year-over-year decline, Mr Yardeni expects that earnings will at least be no worse than they were in the previous quarter, and will perhaps grow modestly.
"The point is that earnings are much better than you might have expected, given the dollar, given what happened to energy and commodity prices, and given the slow growth of the global economy," he said.
What's more, the cash generated by corporate America has allowed companies not only to pay reasonably handsome dividends but also to buy back large quantities of their own shares. These buybacks have strengthened the market: By reducing the number of shares, they have been making earnings per share look much better, and that should continue.
Earnings, and cash from earnings, are the essential core of what you are buying as an investor. But what share price is reasonable for those earnings? At least in part, the answer is, "It depends on interest rates." When interest rates are lower, earnings are worth more and share prices tend to rise, said Aswath Damodaran, a finance professor at New York University, who has explained this truth in elaborate formulas, many of which he posts on his website.
But the simplest way of looking at it, he says, and the most important for an investor, is to consider how interest rates affect the value of a stock and a bond. "Low rates have had a big effect on the stock market," he said. "Stock is much, much cheaper than bonds at today's interest rates."
This comparison may seem odd, if you're not accustomed to thinking this way. It works like this: For the S&P 500, the price-to-earnings ratio is about 20, which means that for every $100 worth of stock, you receive $5 in earnings. By comparison, a 10-year Treasury note, with a yield of 1.6 per cent, pays out only $1.60 for a $100 investment. The bond has a price-to-earnings ratio of more than 60, meaning that it's more than three times as expensive as stock. If interest rates rose to, say, 10 per cent, their rough level in 1979, he said, the price-to-earnings ratio of bonds would drop to 10: Current stock prices would look unreasonably high in that environment, he said.
"In the world we live in right now," he said, "low interest rates make stocks look very good, at least in comparison to bonds."
That's why the latest signals from the bond market, and the latest statements from the Fed, are so important for stock investors. They indicate that while rates are likely to rise moderately in the US in the next year, they probably won't rise very much, and low rates will be with us for some time. Inflation is very low, growth is meager, and the economy is vulnerable to shocks.
In her speech on Friday in Jackson Hole, Ms Yellen acknowledged as much. If the economy continues to improve, she said, the Fed will raise its benchmark federal funds rate, as it has stated for many months. That rate is now between 0.25 and 0.5 per cent. But she also emphasised that the central bank wasn't likely to raise rates very much.
Forecasts show that the federal funds rate will settle "at about three per cent in the longer run," she said. "In contrast, the federal funds rate averaged more than seven per cent between 1965 and 2000." When the next recession comes, she indicated, the Fed may consider experimental methods of influencing interest rates. John Williams, president of the Federal Reserve Bank of San Francisco, set the stage for Ms Yellen's speech with a note, posted this month on the San Francisco Fed website, indicating that interest rates had fallen to a very low "natural level" that is likely to be sustained for an extended period.
This raises complex problems for central bankers. For stock investors, though, it provides straightforward confirmation of a central assumption of the bull market: While there may be some short-term increases, low interest rates are likely to be here for some time to come.
That's not entirely positive. If economic growth were stronger, inflation would probably be higher and interest rates would rise. Without strong growth, churning out robust corporate earnings will be a challenge. For now, though, the twin pillars of the stock market remain intact. That could keep the bull market in stocks, now in its eighth year, cavorting for a while longer.
©2016 The New York Times
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