Major market declines, such as the drop we experienced in June, can cause investors to lose their appetite for risk just as watching the movie Django Unchained (starring Jamie Foxx, pictured above) during dinner might ruin your appetite for that plate of spaghetti and meat sauce that someone just served you. Those market swoons serve as a reminder that, yes, stocks can go down, something that investors might not be too concerned about since the averages have essentially gone straight up since the end of 2012. Whether the carnage is brought on by jittery investors all headed for the exits at the same time, or delivered by Quentin Tarantino in a burst of blood and guts, the results can be pretty messy--and cause us to check our risk exposure and the safety on that gun. So, just what caused the market to reverse its advance, even if that just turns out to be a pause?
There is a showdown on Wall Street now, and to understand it we need to go back to some basics. In very simple terms, a stock's price is a function of two factors: the company's profits, or earnings per share, and the price that investors are willing to pay for those earnings (expressed as the price-to-earnings ratio). As for earnings, a major worry in the market is that the lackluster economic growth we've had since coming out of the Great Recession will hamper corporate profits--and, ultimately, take a toll on stock prices. In the latest round of quarterly earnings reports (commencing again in July), we saw evidence of the economy's sluggish but positive growth in the sales (revenue) numbers, which often came in below expectations even as the profit numbers were beating expectations. Corporations have become quite adept at cutting costs, and the weak labor market has taken wage pressures out of the equation as a problem. Even modest economic growth (that is, we are not in a recession) can pave the way for stocks to do well if companies can take more of each revenue dollar to the bottom line.
On the other side of the gunfight is the value that investors will place on those earnings, a value that is strongly influenced by interest rates. A dollar a year from now is worth more when interest rates are at 2% than when rates are at 4%, for example. The Federal reserve, chaired by Ben Bernanke, has been pumping liquidity into the economy to keep interest rates at rock-bottom levels. One way to look at it is to say that the Fed doesn't want you keeping too much money in the bank, so it's going to create conditions where you are not rewarded for doing so. The Fed wants you to buy a house or start a business, or otherwise go out on the risk curve to put that money to work so that the economy will kick into a higher gear. A stronger economy means more jobs, and the Fed has stated explicitly that it wants to see the unemployment rate lower by about 100 basis points (a full percentage point). Mr. Bernanke and his crew exert this power over interest rates by buying up a slew of bonds--and paying for those purchases with money that they create out of thin air. So the Fed ends up with a bunch of bonds on its balance sheet and the economic system ends up with the cash--cash that didn't really exist before. This has been a big positive for stock prices, as investors seek out the higher returns that can come from taking on more risk (this is known in current jargon as the "risk-on trade."). The June market decline was ushered in by Mr. Bernanke's comments suggesting that the Fed might slow down its bond buying. The prospect of rising interest rates is a headwind for the stock market, often referred to as the Fed "taking the punch bowl away from the party."
Wouldn't it be nice--Nirvana, actually--if we had a strengthening economy to propel earnings and falling interest rates to place a higher value on those profits? Sure it would, but that's not the way the economy works. The Fed is not going to keep pushing down interest rates once the economy really gets going, so if the Fed continues its aggressive monetary accommodation, that is a sure sign that the economy is not getting any better. So, there's the set-up for the showdown that will influence the direction of stock prices. A strengthening economy would be good news, of course, and more robust growth likely would mean better earnings all around. The trade-off, though, is that higher interest rates usually come with the package.
There are a couple of points worth making here amid all of the media chatter about the consequences for the stock market. First, all that talk is about the stock market overall, what we might expect from the average stock. As investors, we are not seeking out the average stock--if that were our goal, we could buy index funds instead of engaging in the meticulous research of true stock-picking. It is true that a bad environment for the stock market is likely to hurt all stocks, but we can at least put the odds in our favor by careful stock selection. As an example, let's take a look at Tile Shop Holdings (TTS, $30), a specialty retailer of manufactured and natural stone tiles that is up 200% over the past year. If you want tiles for your home, you can either go to Home Depot for their selection and probably save some money, or you can go to a professional designer and likely pay a lot more. TTS has created a niche in the middle as a specialty retailer that carries a wide variety of such products, priced above what the big box home improvement stores offer but below the high end. Part of the reason for the strength in the shares is no doubt the improving housing sector, which has made for a nice tailwind. The other reason, though, is that the company has a long growth runway with only 72 stores in 23 states--and plans for a total of at least 100 locations. An intriguing growth story, but rising interest rates could put the housing recovery at risk. So there's the showdown in microcosm--will the growth of TTS be able to overcome the waning of investor enthusiasm for everything tied to housing?
Another point to consider is that the Fed is talking about "easing up on the gas" of monetary stimulus, not "slamming on the brakes" (more jargon!). You might think that this is a critical, finer point that investors have missed--but not so fast. Interest rates may not rise dramatically anytime soon, but it is hard to envision a scenario where they will fall from here, absent another full-blown recession. The issue is not that rates are going sky-high, but rather that we have probably seen the lows in rates for this cycle--and maybe for a very long time. That is not good news for holders of long-term bonds, because the only way to see bond prices appreciate is with falling interest rates. Bond investors who think rates are headed higher should keep their maturities short, so that they can invest maturing proceeds at higher rates.
We'll take our stock gains however we can get them, but I would rather see my stocks propelled by their own earnings prospects rather than by the opiate of falling interest rates. People always ask me if I think the market will go up from here, but they soon catch on to the fact that I am incapable of giving a "yes" or "no" answer. The better question is whether we will continue to see an environment that is favorable for owning equities. Perfection doesn't happen often for the stock market, but a combination of interest rates that don't rise dramatically and an economy that shows better growth would likely keep the rally going. That's a lot to hope for, and unexpected outcomes in either direction could give us Wall Street Unchained, with either blood in the streets or champagne in our glasses.
On another note, I'll acknowledge that it has been some months since I last posted to this blog. I express my sincere thanks to my readers who have told me how much they miss reading these installments. The good news here is that I have been extremely busy engaged in the activities that generate the thoughts and ideas for this space, so expect more regular posts going forward. Thank you.
Life is short. Get busy.
Jim
Disclosure/Disclaimer: My family members and/or I own shares of TTS. Individual stoks are mentioned here for the sole purpose of illustrating investment concepts, and nothing stated here should be construed as advice to buy or sell any security.
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