Sunday, October 08, 2006
Defining "Investing" and the correlationship of Interest rate and Stock prices (Part two)
What had happened in the 17 years starting from 1982? A thing that didn't happen was comparable corporate growth in GDP: In this second 17-year period, GDP less than quintupled. But interest rates began their descent, profits began to climb - not steadily but nonetheless with real power. Then by the late 1990s, the after-tax profits as a percentage of GDP were running close to 6%, which is on the upper part of the "normalcy" band historically. And at the end of 1998, long-term government interest rates had made their way down to that 5%.
With these dramatic changes to the two fundamentals that matter most to investors explain much of the more than tenfold increase in stock prices, though not all - if you recall that the Dow went from 875 in 1981 to 9181 in 1998. What was causing this was also human and market psychology. As always, when a bull market is underway and once you reach the point where everyone had made money no matter what system or method he or she followed, a crowd is attracted into the game that is responding not to the fundamentals - that is interest rates and profits - but simply to the fact that it seems a mistake to be out of the equity markets. In effect, these market participants drive the market prices way over the price which fundamentals allow by having the "I can't miss the party" factor.
In a bull market, everybody's expectation is always too rosy. This kind of phenomena will always exist just like how investor will behave in a bear market where they are overly pessimistic. In a bull market, businesses are mostly valued at a multiple many times over its probable earnings. This can be due to the overly rosy picture painted by Wall Street. In valuing a business, investors must practice logic and realism of achievable earnings. You cannot expect to forever realize an annual gain that is more than the actual gain of profit in a business, though in the interim you can achieve purely because of the rosy paintings but ultimately, the actual results will prove it. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.
An investor must always be aware that any future returns are always affected and tied to the valuations that you give today.