General Market & Business Conditions
By Henry E. StewartIntroduction
Under present market conditions, to be succinct, it is confusing. Recently, since the financial debacle of 2008, there is an unprecedented increase in the money supply as well as a market value of the Dow Jones (a record high). We also have unusually low interest rates for an extended period of time and major corporations are recording increases in profits. Will the market continue an upward increase of value? What will occur if the money supply changes? Are corporate profits due for a reversal or do low interest rates mean continued earnings growth? How do interest rate changes affect bonds? Such are the inevitable questions of inquiry of persons concerned with stock market valuations and investment operations.
While certainly not exhaustive, this short essay is hoped to relieve some of the stress of the reader and provide an alternative insight into the current conditions and valuations (direct answers concerning specific actions or policies of investment finance are avoided but suggestive conclusions regarding valuations are ample). Points of discussion include current conditions and future prospects, interest rates and bond prices, and corporate earnings and valuations. Provision of applicable statistics is provided to aid in understanding the various items of importance. It is the general intent that this short work offers a "breath of fresh air."Current conditions and future prospects
We have strong industrial production (an index at a high), abundance of and continuous increase of population, growing economic output (as measured by Gross Domestic Product), earnings growth of major, well-financed companies (S&P 500 members serve as a proxy), and a general market price increase of these enterprises. We also have significant and unprecedented expansion of the monetary supply (as measured by M2) during a period of economic prosperity (as measured from the point of the last definitive recession).
It appears that there are a considerable number of factors favorable to future industrial expansion and production. The existence of low interest costs indicates a plenitude of money for use by enterprises, either through bankers, or sale of bonds and common stock. The most recent business record further seems to recommend a view of continued prosperity in view of the continual earnings and book value appreciation; market sentiment, as defined by a willingness to pay either a high (in generally prosperous times) or low (typically during times of uncertain outcome) price for earning power and dividends, seems to support a positive future as defined by a consistent and considerable market value increase. Certainly, it appears, quite convincingly, that the current record infers a wonderful future of interest rates persisting at current rates while industrial production and net incomes continuing to rise. On the other hand, an alternative skepticism of prospects may undermine such a rosy future.
There is some reason to consider the merits of the current valuation. The general earning power has increased significantly and therefore warrants a general market price appreciation. Despite earning power increase, however, the appreciation of premium paid for each dollar of earnings indicates a more expensive valuation than in previous years, say, 2010. On a second point, the difference of yields as between general common and those of high-grade bonds has become narrower (from a high earnings yield-to-bond yield of 1.7 times in 2012). And, short-term, sovereign bonds sell at high prices relative to historical averages, yielding, quite literally, a pittance of return (and in some European cases, the bondholder is paying sovereign issuers to repay the principal). It appears, then, that there is a deviation from standard conditions and returns. It will be helpful to examine the items listed in reverse order, starting, first, with the larger money supply, followed by interest rates, and, lastly, the earnings premium on common stocks.Interest rates and bond prices
After investment fallout and ensuing complications in 2008 and 2009, the Federal Reserve effectively increased the money supply by various means and ways. Such actions included the lowering of interest rates and provision of funds to Wall Street firms encountering collapse due to lack of short-term fund availability, i.e. liquidity. In sum, the money supply quite about doubled in a short period of time, and the outcome of the policy shows a subnormal interest rate for a prolonged period.
As a result, other companies are able to obtain capital at lower cost in order to continue expansion of production. The policy seems to show that, in general, such a supply of money, despite a significant increase in earnings and industrial production, depresses chargeable interest cost, which is historically lower than average.
By the same token, from the perspective of the investor, bond prices for offerings prior to the lower interest costs show meaningful price increases as yields declined; and the opposite price behavior may be said of current bond offerings if interest rates increase. In other words, purchasers of longer term bonds at current yields may experience price depreciation if rates improve.
Let us take an example from a well-known, generally sound enterprise, Home Depot. Here, we have a range of coupon rates between 2% and 6% while prices range from $98 to $121 with the longer maturities selling at the higher prices. Other examples include: Wal-Mart bonds priced between $98 and $140 with coupons between 1% and 7.5%; Abbott Laboratories bonds sell at a range of $99 to $124 with coupons between 2% and 6.2%. Overall, the general yield of these examples stands at 4% to 4.5%.
Current high-grade yields, on average as provided by Moody's data, which offer a 4.1% yield, are lower than historical rates. Nonetheless, the yield is not severely low by comparison to historical rates. Certainly, however, the interest earned for the price paid is not advantageous against a historical backdrop of greater rates and compared to the price paid for the initial coupon rate for some of our example bonds. Thus we have a situation whereby the prices paid are notably skewed towards a meaningfully large premium against par. It is apparent then that a return to more normal (higher) interest rates should be seriously considered by those dealing with higher priced bonds.Common stocks
Of course, the primary concern of most readers, the general direction of common stock values occupies the thoughts and considerations of many, especially regarding retirement funds. Without further delay, the merits and dispositions of current market valuations:Points of importance
Though common stock valuations are not definitively low such that the general yield, on average, is, say, 4% or less, and are below the high-grade bond yield, there are other reasons to consider the general market as more expensive than in most instances. First, we have a sustained price increase over a considerable number of years with the result of an increase in premium for earnings. Second, a persistent decline of high-grade bond yields seems to have piqued interest in common stocks, increasing valuations. Third, a significant disparity between the number of industries more dear in value as opposed to those appearing less valuable in terms of market price. And, finally, there is difficulty finding individual issues of common whereby both the financial situation is adequate and price is sufficiently low to warrant further investigation.Sustained price increase
In reflection of the first point, the general market price shows a doubling in a period of six years. While the author certainly does not intend to predict any future change of price, it is notable that continuance of price increases, especially without subsequent earnings and book value appreciation, most usually ends at some future point. The general result in the current market seems to indicate an increase in the average premium for major enterprises.
Individual issues offer examples of companies experiencing greater valuations: Home Depot, selling (as of writing) at 111 against average earnings per share for the past 5 years of about $3.13, represents a premium-to-yield of about 3%. Proctor & Gamble averages $4.10 per share of earnings selling at $80 for a yield of 5%. And we have Reynolds American Incorporated selling at $75 as against average earnings of $2.49 to yield 3.3%. The general yield, then, of these enterprises is significantly low as compared to historical standards.
Certainly, however, not all companies experience the same valuation sentiment. Other cases include Wal-Mart, selling at a price of $71 with average earnings-per-share of $4.91, a more typical 7% yield; we have Abbott Laboratories with per share earnings of $2.58 selling at $49, a smaller premium than that of Home Depot and somewhat greater than that of Wal-Mart, to yield 5.2%.
Interestingly, the directions of the earnings record of the companies offer a clue as to the general direction of price changes and premiums on earnings. Home Depot experienced a doubling of earnings in the period 2010 to 2014, Proctor & Gamble a decline of earnings against an increase in earnings per share, Reynolds American shows a noticeable increase of earnings; Wal-Mart is relatively unchanged, and Abbott shows a decline of earnings by about a half. It seems apparent, then, that growth of earnings-per-share is a primary factor of market sentiment at this time.
On an aside, perusal of the so-called "blue chip" companies also shows an apparent increase in the issuance of debt and payment of dividends or repurchase of common. The net effect seems to be a decline in net book value for some of these companies, and a corresponding increase in the premium per dollar of net book value.Relative yield of high-grade bonds and common stocks
With respect to valuations relative to those of high-grade bonds, the market seems to value each dollar of earning power in 2014 as greater than those dollars earned in prior years, say, 2009 to 2011. The greater valuation placed on earnings appears to be the result, at least partially, from the decline of interest rates on high grade bonds and, also, the belief that corporate earning power will continue to increase.Disparity between dear and undervalued industries
Concerning the third position, there exists a scenario where the number of industries, with at least some notable number of companies represented, that are clearly priced more highly than the market average is grossly larger than those with a much lower valuation. Further survey of the figures shows that the dearer industries possess incredibly greater valuations per company, on average, than those of the cheaper industries. On an anecdotal basis, it seems that the touted industries have major representatives of recognizable names whereas the less valued industries have recognizable though less known brands and are smaller companies. Provided are figures illustrating this point. Note that the data and listing of industries is not exhaustive.
Dearly valued industries are marked by price-to-book in excess of 3 times and earnings pricing greater than 25 times; companies of small valuations (less than $1b) are excluded. The most commonly expensive industries relate to healthcare, technology or restaurants. The total number of common stocks after adjusting (excluding) for funds shows 513 common stocks of notably greater valuation.
Figures in millions
a: inclusive of major, generic, and other manufacturers and wholesale distributors.
b: inclusive of laboratories, equipment, appliances, instruments and supplies.
There are numerous other industries with some number of companies featuring representation of dear valuation include air delivery and freight services (United Parcel Service), asset management (fund companies), auto parts, beverage producers (Monster Beverage Corp., Brown-Forman Corp., Constellation Brands, Inc.), credit services (VISA Inc., MasterCard Inc.), discount stores (Family Dollar Stores Inc., Dollar Tree Inc., Costco Wholesale Corp.), general building materials, home furnishings, various technology-related (software, hardware, services; information) industries, long-term care, lodging, lumber, oil & gas, resorts & casinos, among many others.
Lesser valued industries are marked by price-to-book less than twice the value and earnings pricing less than 10 times; companies of small valuations (less than $1b) are not excluded. There exist numerous specific funds and real-estate investment trusts showing outsized representation relative to the number of industrials, banks, etc… and are therefore not considered part of the statistics as they are not a business operation in the same nature as an industrial or bank for instance. This includes a total of 86 funds. The total number of common stocks after adjusting (excluding) for funds shows 148 common stocks of notably lower valuation without reference to financial quality.
Figures in millions
Disregarding financial strength, the number of common stocks of greater valuation are 513 compared to 148 of a lower valuation. That is a ratio of nearly three-and-a-half times. By simple observation we have fewer companies of lesser value and more companies of greater value. Hence, the general market undoubtedly implies favoritism for industries yielding less than the average yield of major representatives of American business and this favoritism appears to carry towards those firms exhibiting growth of earnings, or even decline of earnings as against increase of earnings-per-share.
Thus these certain profitable industries, according to market sentiment, will continue to improve in earning while those experiencing lower valuations will undergo earning power losses. In other words, market sentiment computes a continuance of poor prospects for these companies. However, the less valuable industries are certainly of importance. Generally familiarity with oil & gas, banking and credit firms, and property & casualty insurance indicates that these industries certainly are integral parts of a functioning business and economic environment. Therefore, the extent to which the undervalued industries will suffer earnings losses sufficient to reduce earnings yield to a significantly lower rate, as implied, seems questionable; though individual issues within these industries certainly require more in-depth research than a cursory glance for further discussion of this point.Availability of individual issues
As to the final concern of individual issue availability, such a matter is subjective as determined by the standards and measures of the analyst. No definitive and exacting proposition is made regarding this point. However, in the endeavor to avail oneself of opportunities in the securities markets, the current valuations make locating such issues more difficult.Conclusion
As discussed, there exists a period of prolonged decline in interest rates amid a strong corporate showing. Though proposing a hypothetical (or set of) situation(s) is tempting, the character of economic, industry, and market valuation bewilders any certain analysis. However, it does seem apparent that the prerequisites, such as capital and population, for continuing industrial production growth are available and ample. Hence, the sale of bonds and common shares by companies. Certainly such actions enable companies to utilize capital for improvements and production in the future. However, to what effect on future earning power these appreciations accumulate, it is difficult to determine.
Concerning valuation, it is the author's impression that the general market is experiencing a dearer period for both high-grade bonds and common stocks during a phase of continual improvement of industrial production and earnings. There is some certainty that there is likelihood of an effect, such as from the Federal Reserve or by way of general cost increases, that may cause a change of interest rates, and commensurate valuations. Other items such as calamities or events, foreign or domestic, may impose a change in general market sentiment. History suggests that price depressions may occur suddenly and for an extended period of time. Thus, it is proffered that considerable caution be exercised in the purchase of securities if the price may be less advantageous, especially if purchased prior to periods of lower general market values.Figures Present statistical showing
1: the year 2009 shows the start of the currently sustained general market increase.
Note: original figures from through year-end 2011 are given in same year dollars as given by Shiller data; thereafter, statistics gathered through 2014 are denominated in 2015 dollars and thus are converted to 2013 dollars. Small variations of less than "1.00" may exist between different sets of the same figures.The following is a historical showing during a low and high point of market valuations for common:
In the illustration below, yields of common stock and high-grade bonds are compared. Please note that the scale is inverted, i.e., lower interest rates (greater prices) are at the top of the vertical axis and higher interest rates (lower prices) are nearer the bottom of the graph.Sources
Shiller, Robert J., Chapter 26 in "Market Volatility", 1st Ed.
Cambridge: Massachusetts Institute of Technology, 1989
"Industrial Production Index." Federal Reserve Bank of St. Louis, Economic Research (https://research.stlouisfed.org/fred2/series/INDPRO)
"3-Month Treasury Bill: Secondary Market Rate." Federal Reserve Bank of St. Louis, Economic Research (https://research.stlouisfed.org/fred2/series/TB3MS)
"FinViz.com Stock Screener" for compiling industry data (finviz.com/screener.ashx)
"Morningstar" for bond prices and yields (www.morningstar.com/)
Annual reports of respective companies for earnings-per-share figures found in "Selected Financial Data" section.