Keep connected
Our investment management team is made up of engaged thought leaders. Get their latest commentary and stay informed of their frequent media interviews, all delivered to your inbox.
On top of that, the argument has always been that P-E multiples should be higher during periods of lower interest rates, suggesting that P-E multiples should be higher given that interest rates are at all-time lows and the world’s major central bank, the U.S. Federal Reserve, advocated in the minutes from their recent meeting that interest rates should be kept low through to at least 2015! The monetary argument favouring stocks (also called the ‘liquidity trade’) should be getting substantial support from that interest rate outlook. Other central banks will be following suit as well, followed most immediately by the European Central Bank (ECB).
Our stock market strategy has always been ‘Top-Down’ in nature. In any top-down strategy, the level and direction of interest rates is always the starting point. The logic is that lower interest rates stimulate the global economy through higher corporate and consumer spending which then flow to the profits of corporations and then to stock valuations as shown in the flow chart below. This contrasts with traditional ‘bottom-up’ analysis which focuses primarily on the profits and valuations of individual stocks. But there is also another mechanism where interest rates directly impact the stock market, and this is referred to as the ‘liquidity trade.’ Since the flow of money to stocks is also impacted by the level of alternative investments, such as fixed income investment such as bonds. As interest rates go lower, the less attractive these fixed income alternatives become compared to stocks (i.e. a stock with a 4% dividend yield is a more attractive investment when other interest rates are at 1% as opposed to when they are at 7%).
The point here is that the recent round of central bank intervention pretty much guarantees that interest rates should stay lower for a longer period of time than previously thought. Even if this doesn’t do much to improve the global economy, it should drive more money into stocks based solely on this ‘liquidity trade’ argument.
Recent news on the earnings front has not been supportive of the stock rebound however. ‘Earnings confession’ season has started with 2 major bellwethers, rail company Norfolk Southern and delivery king FedEx, each warning that third quarter earnings will fall short of expectations. FedEx, in particular, pointed to weakness in China as being the main culprit for the shortfall. Both of these companies are great indicators of general economic conditions, simply on the well worn theory of Charles Dow, developed in the 1920’s, that if goods are produced and sold somewhere, they also have to be transported to that location. Rail and delivery companies would see the bulk of that traffic, so earnings warnings from such transportation companies should not be taken lightly. Our expectations for third quarter earnings are not particularly robust, with year-over-year growth in the single digit range. But with low stock valuations and the support from lower interest rates, investors might look beyond some of this weakness to a recovery in the 4th quarter and into 2013. Company guidance on the earnings reports should set the tone for the balance of this year.