"Moneyball," by Michael Lewis, is about how Billy Beane with the Oakland Athletics exploited new model for how to win in baseball. Even casual baseball fans know that in order to get wins, you build a team to score runs and prevent runs. Conventional wisdom was that a player's contribution to scoring runs was based on batting average, runs batted in (RBIs), and home runs. Beane leveraged what seems obvious - that RBIs were a result of other things like having men on base when the player is at bat.
They figured that the broad measure of getting on base and not making an out was much better than the narrow measure of hits and batting average. Walks had largely been ignored. Beane and the A's figured out more walks equals more runs and set out to target players for their ability to get on base rather than get hits. Importantly, they also quantified the impact by developing new models to predict run production.
What does this have to do with the stock market? Many people look at the P/E ratio (price-earnings) ratio as a driver of stock price, since by definition, earnings times market P/E equals price. Like RBIs the P/E ratio is not a driver but a result. The P/E ratio is like RBIs, it's driven by another factor - interest rates. Long-term interest rates are like walks for the stock market. Just as walks drive run production, interest rates drive the market P/E ratio. When you combine the predicted P/E, based on current interest rates, with actual earnings, the model provides an accurate measure of intrinsic value for the S&P 500.
In my book, "The Risk Premium Factor," I quantify the impact of interest rates on P/E and stock price. Despite its geeky name, it is Moneyball for the stock market and can be understood by anyone who has mastered long division. And frankly, if you haven't mastered long division, you probably shouldn't be managing investments on your own. I've also written on this subject in a number of articles on Seeking Alpha where I introduced it with "A Simple and Powerful Model Suggests the S&P 500 Is Greatly Underpriced."
Actionable insights include:
- Half of the dramatic rise in the market from 1980-2000 was due to interest rates.
- The 1987 crash was foreseeable if you looked at interest rates.
- The 2000 crash was foreseeable if you looked at interest rates.
The importance of interest rates on stock price should be as obvious the impact of walks on run production. If government bonds are guaranteeing you more than 10%, like they were in the early 80's, you'd have to expect to earn more than that by taking a risk in the stock market. My innovation, the Risk Premium Factors, says that the higher interest rates are, the greater the premium investors expect. The higher expected return results in a reduction in price, since higher interest rates drive P/E lower.
Many have discussed and compared interest rates to P/E ratio. Interest rates are often compared to earnings yield, E/P, the inverse of P/E ratio. The Risk Premium Factor Model takes that notion a step further and quantifies the impact.
Stock prices are driven by just three things
- Earnings. Cash flow drives value and earnings, especially when looking at the entire market, are a good proxy. Almost everyone already understands this.
- Interest rates. As discussed earlier, most people don't recognize that yields on long-term Treasury bonds, interest rates, drive the cost of capital, which in turn has a huge impact on stock price. Higher rates lead to lower P/E ratios.
- Growth. For the overall market this is simply the expected long-term growth rate for the economy which is generally stable. Remember, this long-term not last year or next year, but over decades. For individual companies this quite volatile, and the biggest driver of stock price. Whether you are public or private, if investors believe in your long-term growth story, your company will be more valuable which, in the case of public companies, it's manifested in P/E ratio.
This comes together in a simple formula that helps you understand the intrinsic value of the stock market:
P = E / (C - G)
This tells us that price is a result of three factors, where E is for earning, C is for the cost of capital which is driven by interest rates and G is growth. That's it. The chart above shows the results of this model when compared to the S&P 500 from 1960-present. You may recognize that this is a simple perpetuity formula. The difference, as described above, is in how the inputs are determined.
The Market Makes Sense
When many people think of the stock market, they conjure up an image of the 1987 movie Wall Street complete with the crazy of its co-star Charlie Sheen. The truth is far from that. Over long term, the market is in fact, not only rational, but easy to understand and almost reptilian in response to readily observable factors. The ways of the market are actually simple and straight forward. The RPF Model explains it.
Disclosure: I am long SPY and short long-term Treasuries.
