We have found that very few investors understand what really drives the stock market. In our view, the four primary drivers of market valuations are earnings, dividends, interest rates and inflation. If you can quantify what is going on with those four variables, our models indicate that you can predict about 90% of the annual movement of stock prices.
Last time, we talked about the Barnyard Forecast which is a model that signals the probable direction of the market. While the Barnyard Forecast does correctly predict the market’s direction 6 to 18 months from now with about 80% accuracy, it is not a short-term predictor nor does it have any valuation component. Therefore, we use select valuation models to ascertain the relative attractiveness of stocks.
Almost all of these models use some component of the above mentioned variables. Within those four variables, there are two that stand out above the others as being the most important drivers. We’ll take a look at each factor and then conclude with what it means for stocks.
Most investors look to earnings as the primary guide of what a company is worth. In theory, that makes sense. If Company A is earning $500 and Company B is earning $1,000 - wouldn’t you rather own Company B?
The problem with earnings is that they can be engineered by creative corporate executives. In times of recession, earnings are particularly volatile. Earnings can be calculated in a variety of different ways, which adds additional complexity. We don’t think earnings should be completely discounted in valuing companies or the stock market as a whole. However, the unpredictable nature of earnings often gives very bad signals at turning points in the market.
We have found dividends to work much better than earnings. Over the past 50+ years, dividends have had approximately three times more predictive power than earnings.
Let’s say you own two rental properties. One rents for $100 per month and the other rents for $200. If both rents are increasing at 3% per year and both will continue to rent for the next 20 years, which rental property would be worth more to you? The one that will pay you the most in rental income over its useful life… right?
John Burr Williams was the first to apply this theory to stocks. He said the value of a stock today is the sum of all future dividend payments discounted back at some required rate of return. In other words, the more a company pays out to its owners in the future, the more valuable that company is to its owners today.
Not only does that theory make “real world” sense, but it also holds up statistically. In our models, we’ve found that dividends are the most important driver of stock prices by a wide margin.
Interest rates are a primary concern for most stock investors. The general level of interest rates essentially represents the “opportunity cost” of investing in stocks.
If your bank account were to start offering 10% per year on your savings account, you would probably prefer to “invest” in your savings account rather than in the stock market. If your bank account is only paying 0.1%, however, the attractiveness of investing in stocks increases.
Many investors would be surprised, however, that interest rates are not the most important factor in determining long-term stock prices.
Inflation is actually a much more significant predictor. How can that be? There are several reasons for this.
Interest rates can be artificially set by the Federal Reserve. Inflation can be influenced by Fed policy, however, it is primarily a result of real world economic activity.
Inflation is also one of the primary drivers of interest rates. If inflation is rising, it has the effect of diminishing the real rate of return for a bond investor. In that environment, a bond buyer will demand a higher rate of interest to compensate for the loss of purchasing power.
In addition, inflation is impacted to a large degree by economic growth. When the economy is growing at a faster rate, the Federal Reserve will generally tighten monetary policy, which raises interest rates.
The importance of inflation is also reflected in several of our models. We have a price-to-earnings (or “P/E”) Finder model that we use to determine the appropriate P/E ratio for stocks. In that model, inflation has been a much better predictor of P/E than interest rates, GDP growth or earnings growth expectations.
Outlook for Stocks
If you can understand these four variables, you can get a fairly accurate gauge of the valuation of the market. At this moment, all of these variables are very positive for stocks.
- Dividend growth for the S&P 500 has been over 10% year-to-date. We believe this will continue to be strong in 2015. Companies are beginning to understand how valuable their dividend checks are to shareholders and have begun to emphasize dividend growth as a priority.
- Earnings are expected to grow by over 10% in 2015. Time will tell whether that will come true or not. If it does, we anticipate the market will reward the companies for their continued strong performance.
- Inflation remains very low. With little capacity pressure from either employment or plant and equipment, we don’t see much of a chance that inflation gets higher than the Fed’s target of 2.5%. The economy is simply not growing fast enough.
- With inflation low and the Fed continuing their stimulative monetary policy, interest rates are likely to remain low. The 10-year Treasury continues to trade at the low end of our 2013 prediction of between 2.5% and 3.0%. We don’t anticipate that rates will get much higher than that over the near term.
As we talked about last week in our Barnyard Forecast, monetary policy conditions are very favorable. Aside from a major geopolitical shock, stocks don’t face any major red flags going into 2015.
The most current reading from our S&P 500 valuation model indicates that the fair value of the market is about 1,950. As this is being written, the S&P 500 is trading at about 1,952. From both a directional perspective and a valuation perspective, our models are saying that stocks are still the place to be.