Sunday, October 08, 2006
Defining "Investing" and the correlationship of Interest rate and Stock prices (Part one)
More often than not in investing, many market participants focus too much on what the price of the stock will do rather than what the asset of the business will produce. Many will also focus too much on valuing a single business by valuing it together with the total valuation of the overall market, i.e a business is valued as how the whole industry or economy is performing, hardly on the scale of what the business itself does. When investors follow these strategies, any fool can do a job of similar outcome. When the tide rises, all rises, when it draws back, everyone sinks! On my blog, I shall focus almost exclusively on the valuations of individual businesses, looking only to a limited extent at the valuation of the whole market. The worst is to based one's judgment on a favorite header like "Shares end up mixed due to a lack of leads."
Let's start by defining "investment." The definition is simple but often forgotten: Investing is laying out money now to get more money back in the future - more money in REAL terms, after taking inflation into account.
Now, to get some historical perspective, let's look back into 1964 through 1998 to observe what happened in the stock market. Here you will observe an almost symmetry duration of lean years and fat years. To begin, the first 17 years of the period, from the end of 1964 through 1981, here's what took place in that interval:
Dow Jones Industrial Average
Dec 31, 1964: 874.12
Dec 31, 1981: 875.00
Even though you may be a patient guy and long term investor. That is not an idea of a big move. And here's a very striking and contrary fact: During the 17 years, the GDP of the U.S. - that is, the business being done in the country - almost quintupled, rising by 370%. Or, if we look at another measure, the sales of the Fortune 500 (of course then, the mix of companies were different) more than sextupled. And yet the Dow went exactly nowhere.
This is an amazing phenomena if you look at it just like that. To understand why that happened, we need to look first at one of the two important variables that affect investment results. These acts on financial valuations the way gravity acts on matter.
1) Interest rates. The higher the rate, the greater the downward pull. That's because the rate of return that investors need from any kind of investment are directly tied to the risk-free interest rate that they can earn from government securities. Thus, if the government rate rises, the prices of all other investments must adjust downward, to a level that brings their expected rates of return into line. Conversely, if government interest rates fall, the move pushes the prices of all other investments upward. The basic proposition is this: What an investor should pay today for a dollar to be received tomorrow can only be determined by first looking at the risk-free interest rate. Consequently, every time the risk-free rate moves by one basis point (0.01%), the value of every investment in the country changes. It is easy to see this effect in the case of bonds, whose value is normally affected only by interest rates. In the cases of equities, real estate or whatever, other important variables are almost at work, and that means the effect of interest rate is usually obscured. Nonetheless, the effect is constantly there though like the invisible pull of gravity. In the 1964 to 1981 period, there was a tremendous increase in rates on long-term government bonds, which moved from 4% in 1964 to more than 15% by late 1981. So there - in that tripling of the gravitational pull of interest rates - lies the major explanation of why tremendous growth in the economy was accompanied by a stock market that went nowhere. Then in the early 1980s, the situation reversed when the then unpopular FED chairman, Paul Volcker, did the heroic thing by breaking the back of inflation, causing the interest rate to reverse, with some spectacular results from 1981 through 1998 - a similar length of period lasting 17 years.
1981 - Interest rate at sky high 15% with Dow at 875
1998 - Interest rate at about 5% with Dow at 9181
2) After-tax corporate profits as a percentage of GDP. This is the second factor which has a bearing on the stock prices during the first 17 years. From 1951 up to 1981, the percentage is always between 4% to 6.5%. Then by 1981, the trend was headed towards the bottom of that band, and finally in 1982, profits tumbled to 3.5%. So at that point, investors were looking at two strong negatives: Profits were sub-par and interest rates were sky-high.
And as is so typical, investors projected out into the future what they were seeing. That's their unyielding habit: looking into the rear-view mirror instead of through the windshield. What they were observing, looking backward, made them very discouraged about the country. They were projecting high interest rates, low profits, and they were therefore valuing the Dow at a level that was the same as 17 years earlier, even though GDP had nearly quintupled.