The equity market seems complex, but it is really much simpler than you think. There are only three things that move the market. The following article will identify the three cause and effect relationships and use this framework to examine recent market events, including the taper and Syria.
The Three Things
Every move in the equity market can be traced back to changes in one or more of the following three valuation factors: earnings expectations, the risk-free interest rate, and the market risk premium. Future earnings are obviously not known in advance, but market participants continuously update their earnings expectations as new economic information becomes available and global events unfold. Earnings expectations have a direct effect on equity prices: increasing earnings expectations raises equity prices and vice versa.
The risk-free interest rate and the market risk premium both have inverse effects on equity prices. The risk-free interest rate plus the market risk premium equals the required rate of return on equities. The required rate of return is expressed as a percentage and changes continuously in response to fluctuations in the risk-free interest rate and the market risk premium. Increases in the required rate of return on equities lowers equity prices and vice versa.
Equities represent a claim on a perpetual stream of future earnings. Unfortunately, those earnings occur in the future and we are interested in the value of those earnings today. To determine the value of a future cash flow stream, we need to discount the expected future cash flows by the required rate of return. In other words, the present value (the value today) of the future cash flows will be lower than the nominal amount of those future cash flows received in the future. An increase in the required rate of return reduces the present value of the cash flows, which means equity prices decline.
A Mathematical Digression
The most common valuation model taught in business schools is the dividend discount model, which assumes that dividends grow at a constant rate in perpetuity. While this is obviously unrealistic, the model does help illustrate the above relationships. In the first formula below, S represents the stock value, D1 equals next year's annual dividend, K is the required rate of return on equities, and g is the constant annual growth rate in dividends and earnings.
S = D1/(K-g)
Notice that the valuation formula above uses dividends not earnings. Next year's dividend (D1) equals next year's earnings (E1) multiplied by the payout ratio (b). As a result, we could rewrite the above formula using earnings instead of dividends.
S = (E1*b)/(K-g)
An increase in future earnings would increase E1, which would cause S to rise. In addition, an increase in the earnings growth rate (g) would reduce the denominator, which would also cause S to increase.
Based on the above formula, it would be tempting to conclude that increasing the payout ratio (b) would also increase S. Unfortunately, increasing the payout ratio means increasing the portion of earnings paid out as dividends, which reduces the reinvestment of earnings reinvested into future projects. This would reduce the future growth rate (g), which would reduce S. As a result, it is not possible to increase equity values by increasing the payout ratio. Future earnings drive equity prices, not future dividends. Many companies increase their dividend growth rate without a corresponding increase in their earnings growth rate. This requires a sustained increase in the payout ratio, which eventually leads to insolvency. Many investors incorrectly focus on dividend growth instead of earnings growth.
You will recall that the required rate of return (K) equals the risk-free interest rate (Rf) plus the market risk premium (MRP).
K = Rf + MRP
When the risk-free interest rate (Rf) increases and/or the market risk premium (MRP) increases, the required rate of return (K) will increase, which will cause equity prices to decline. The inverse relationship between equity prices and the required rate of return exists because K is in the denominator of the valuation equation above.
The Three Factors in Practice
The academic formulas above are too blunt to value the equity market precisely, but they do illustrate the cause and effect relationships of the three valuation factors. Before applying this framework, we need a market proxy for the risk-free interest rate. For the U.S. equity market, the best proxy is the yield of the 30-year U.S. Treasury bond. Since we are valuing a perpetual stream of future cash flows, we want an instrument with a long-maturity, hence the 30-year bond. Treasury bonds are backed by the full faith and credit of the U.S. Government, which is not as impressive as it once was, but is still our best proxy for a riskless asset.
Now, let's look at the impact of some events on the U.S. equity market.
GDP Stronger than Expected
Stronger than expected economic growth would suggest increased spending by consumers and business, which would lead to increased earnings and higher stock prices. Depending on the environment a surprisingly strong GDP report could also lead to a less accomodative monetary policy and higher interest rates. This effect would mitigate the effect of rising earnings.
Monthly Employment Report Weaker than Expected
Lower than expected job growth would suggest weaker income growth, lower consumer spending, and a decrease in earnings expectations. As always, economic reports that affect earnings expectations could also affect Fed policy. The relative magnitude of these offsetting effects will depend on the economic environment and on the responsiveness of the Federal Reserve Board.
Fed Taper - Reducing QE Purchases
The tapering of asset purchases by the Fed would increase the risk free interest rate, which has already been evident in the bond market. The Fed is a non-economic buyer of Treasury and mortgage-backed securities, which has artificially depressed interest rates and held them to below market levels for an extended period of time. Once the Fed stops buying (even if it does not immediately begin selling), yields on Treasury and mortgage debt would be set by economic buyers and sellers. This has not happened since 2007, so there is a great deal of uncertainty about the "correct" level of yields. If and when the Fed begins liquidating its unprecedented debt holdings, the supply of additional debt would result in even higher yields.
The situation in Syria is different than those above. At this stage, some response by the U.S. is expected, but the exact magnitude and duration of that response is unclear. In addition, there are other unanswered questions. How would Russia and Iran respond to U.S. military intervention? As you can see, there is a great deal of uncertainty surrounding this issue. The market hates uncertainty; uncertainty means risk. When uncertainty increases, risk premiums increase.
It is difficult to see how a limited and measured response by the U.S. would lead to a material decrease in future earnings. While there could be a short-term spike in oil price, which acts like a tax on consumers, the spike would presumably be temporary.
The interesting question is what would happen in the event of a U.S. military response in Syria. As mentioned above, long-term earnings expectations should not be affected materially. Treasury yields could decrease temporarily due to the typical flight to quality response. As the extent of the U.S. attack and the response from Russia and Iran became clear, uncertainty would be greatly reduced and risk premiums would decrease. The market could rally, even during the conflict. This is the most likely scenario.
However, if the conflict escalated and turned into a protracted air and ground offensive, risk premiums could remain elevated for an extended period and the fiscal health of the U.S. could be further weakened due to the cost of the military operation - as we saw in Iraq and Afghanistan. This could adversely affect earnings expectations.
The next time the market responds to a new piece of technical or fundamental information, ask yourself how each of the three factors were affected and how long those effects will persist. This will help you understand how to implement your investment strategies in any environment.
Trader Edge Strategy E-Subscription Now Available: 20% ROR
The Trader Edge Asset Allocation Rotational (AAR) Strategy is a conservative, long-only, asset allocation strategy that rotates monthly among five large asset classes. The AAR strategy has generated 20%+ annual returns over the combined back and forward test period (1/1/1990 to 7/29/2013). Please use the above link to learn more about the AAR strategy.
Your comments, feedback, and questions are always welcome and appreciated. Please use the comment section at the bottom of this page or send me an email.
If you found the information on www.TraderEdge.Net helpful, please pass along the link to your friends and colleagues or share the link with your social or professional networks.
The "Share / Save" button below contains links to all major social and professional networks. If you do not see your network listed, use the down-arrow to access the entire list of networking sites.
Thank you for your support.
Copyright 2013 - Trading Insights, LLC - All Rights Reserved.