By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
The lesson of 1998 is that interest rates trump earnings.
When the final numbers are in, 1998 seems certain to be the first year since 1991 that earnings fall. The fact that as of Friday it also looks like another double-digit year for stock returns attests to how much rising valuations, driven by falling interest rates, can propel the market.
Of the 150% rise in the Standard & Poor's 500-stock index since the end of 1994, less than a third has come from higher earnings. The remainder has come from the rising price investors pay per dollar of earnings -- the price/earnings ratio. That has become especially dramatic this year. Through Friday, Standard & Poor's 500-stock index was up 20.2%. But according to IBES International, an analyst-estimate tracking service, operating profits for the S&P 500 companies are also expected to fall 1% this year. Thus, all the advance in the market has been thanks to a rise in its P/E ratio. It now stands at 26 times current year earnings, compared with 21.5 at the end of 1997, an increase of 21%.
It owes that primarily to falling interest rates. The 30-year government yield fell to 5.02% Friday from 5.93% at the end of 1997.
"There's always been an inverse relationship between interest rates and P/E ratios," says Ed Keon, director of quantitative research at Prudential Securities. "With much less return for your money in fixed income, it makes sense to pay a higher P/E."
The question facing investors is whether interest rates can continue to trump earnings if next year turns out, as some fear, to be another difficult one for profits. Most investors are worried about the earnings outlook and valuations, but equally they are comforted by the support from the lowest interest rates since the 1960s. A press conference last week given by mutual-fund manager Federated Investors neatly captured that dichotomy.
"When central banks are pumping liquidity into global financial markets around the world, stock prices tend to rise," says Thomas Madden, the firm's chief investment officer for domestic stock, high-yield bond and asset-allocation funds. So even though valuations are "challenging," he believes a Dow Jones Industrial Average of 10000 early next year "is not an especially aggressive forecast." On Friday, the Dow Jones Industrial Average fell 19.82 points, or 0.2%, to 8821.76, leaving it up 11.6% for the year.
On the other hand, Aash Shah, manager of Federated's Small Cap Strategies fund, asserts, "It doesn't matter what the Fed is going to do.... The No. 1 factor for stocks is earnings growth." He allows that in the short term, the Fed does matter, but over more than five years, "earnings growth overwhelms all other factors in determining performance."
Lower interest rates have their most-powerful effect boosting P/E ratios of reliable growth stocks, for which the majority of their earnings lie far in the future. That is one reason that the largest growth stocks such as Microsoft and Cisco Systems have led the market all year and propelled the index of Nasdaq's 100 largest nonfinancial stocks to a 69% year-to-date gain. On the other hand, the Russell 2000 index of smaller capitalization companies, whose earnings are less predictable than those of larger firms, is still down 9.5% for the year. Federated's Mr. Shah thinks small stocks are poised to perform strongly thanks to lower valuations and higher earnings growth.
But investors hoping that interest rates will deliver another solid year of returns next year might be disappointed. "There just isn't much more room for interest rates to drop," says Mr. Keon. "So there's just not much room left for [P/E] multiple expansion."
And the story could be even worse if profits don't perform well next year. "Earnings expectations are still very optimistic," says Richard Bernstein, head of quantitative research at Merrill Lynch. He notes his firm's industry analysts in total expect S&P 500 profits to grow 20% next year, while its strategists and economists are looking for a decline. "There hasn't been acceptance that there's a profit problem. So I think negative earnings surprises over the next six months could be very powerful. The question is then, are interest rates powerful enough to offset those weak earnings?" He thinks not. And he warns that the overall economy is not as weak as profits, reducing the likelihood that the Federal Reserve will cut interest rates any more in 1999.
That seems to be the lesson of last week's activity. The industrial average fell 248.71 points over the past four days of the week as components J.P. Morgan & Co., Merck, Union Carbide and Coca-Cola all warned analysts their profits wouldn't meet expectations. That said, traders see little pressure on the overall market from specific warnings. For example, Coke's warning Friday dragged it down 3 3/16 to 62 7/8, but that accounted for almost two-thirds of the fall in the industrial average. Traders say the bigger contributor to stock weakness has been unsettled conditions abroad and the advancing impeachment process in Washington.
Many strategists figure that stocks are fairly valued when their earnings yield -- which is the inverse of the P/E ratio -- is equal to bond yields. Thus, if bond yields are 5%, then stocks are fairly valued at about 20 times the coming year's earnings. But there's a problem with this model. As Charles Hill, director of research at First Call notes, it would imply Japan's bond yields of 1% and lower, deserve stock P/E ratios of 100 or higher. That seems to indicate that falling interest rates stop helping stocks when they show the economy is in deep distress, bordering on deflation. Could it happen here? The fact earnings are falling without rising interest rates is a "symptom of the current deflationary environment," argues the Bank Credit Analyst, a financial-forecast journal. In times of deflation, it's easy for stock prices and interest rates to fall at the same time. While not forecasting deflation, the Bank Credit Analyst argues, the profit outlook is tough and "there is probably too much complacency about the potential for easier monetary policy to impact the long-run earnings picture."