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Why Stock Markets Correct*

There is a simple reason why stock markets correct.

Relative value.

Interest rates are somewhere between 3% – 4%. The Price/Earnings ratio on bonds, therefore, is between 33x and 25x. ($100 / $3 or $4). Bond investors can earn $1 of interest income for a $25 – $33 investment.

Compare this to the P/E for stocks.

The stock P/E depends on how you calculate it. Some use the average of ‘actual’ earnings over the last 10 years (Shiller’s P/E, currently above 22x). Others ‘estimate’ future P/E using analyst consensus future earnings estimates (about 13x at March month end). See Slim Pickin’s.

By these measures, the stock P/E range is between 13x to 22x.

Sionna’s Kim Shannon says it’s 20x.

The point is that stock investors can earn $1 of income for a $13 – $22 investment … meaning … stocks, today, are the better investment relative to bonds.

But investors don’t buy stocks for today.

And it only makes sense to buy stocks for tomorrow if:

One. Investors believe interest rates will drop (even further). Stocks would (still) look relatively better (as the earnings i.e. interest, on bonds drops).

Will interest rates drop? In a recent presentation to the CFA audience, Peter Gibson from CIBC World Markets, builds a convincing argument that says Governments, (all Governments), having high debt levels, cannot and will not allow interest rates to move outside the 3% – 4% range (except maybe temporarily higher to fight inflation). We will see 3% – 4% interest rates for years, he says. There is little room for rates to move higher or fall further. See ‘Sideways Drift.

Two. Investors believe that corporate earnings will increase … making stocks (still) look relatively more attractive than bonds.

Will corporate earnings continue to grow at their recent rapid pace? Many strategists and analysts now foresee slower corporate earnings growth ahead. Even the usual optimistic view from J.P. Morgan is more moderate – “recent momentum in earnings estimates for developed markets now appear to have come to an end George Iwanicki, Macro Strategist, JPM.

Further, John Bogle has said about corporate earnings – “the corporate share of GDP—corporate earnings after taxes as a percentage of GDP—generally runs about 6 percent. Sometimes, it drops to 4 percent; sometimes, it goes up to 8 percent. Near the end of 2007, it was about 10–11 percent. Corporate earnings’ share of GDP is almost by necessity a very stable number”. (See chart).

When (not if) corporate earnings slow, P/E multiples will drop.

If bonds are constrained by interest rate movements and if interest rates don’t (cannot) move, then, to realign the relative value of the stock market with the bond market, stock prices must drop.

*With apologies to Michael Lewis, ‘Panic: the Story of Modern Financial Insanity’.

Next time?
Economic Indicators.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Plan
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