Zaks Investment Advisory Service

What Determines Stock Price Levels?

Today, after several programs on Emerging Markets, I would like to return to our own market and take a look at it from different perspective. As you know, the indexes have been recently lagging at some of their lowest levels in the past 12 months. Why? To try and answer this question, let us recall what determines the price of shares on the stock exchange. Stock prices are determined by two factors: future earnings and future interest rates. Image that a certain company’s stocks (we will call the company ABC) are trading at a level of $50 per share. Now suppose that the market has received news suggesting that the company’s earnings will grow next year (for example, the company’s president issued an optimistic forecast during a conference call with Wall Street analysts). As soon as this information spreads, and it will do so very quickly, the price of ABC shares will go up. We must keep in mind that stock prices move on news – i.e. things the market had not been previously aware of. Current prices include all of the current information, in other words, everything the market already knows about individual companies and the market environment as a whole. I mentioned there were just two factors that determine stock price levels. But the amount of information that moves the market and which affects these two factors is vast. This information includes all the news about the various companies, as well as that about inflation, interest rates, the price of oil and other commodities, political developments from across the world, and so on. The market (i.e. all of its participants) processes all this information and comes up with the market price for the stock.

Now imagine the following: financial analysts believe that ABC will earn $2 per share in the next quarter. Several weeks pass and the company comes out with a report stating that indeed it expects to earn $2 per share. Formally, this is news – in the sense that this information will appear in the financial media. But this is not new information for the market: it has already been incorporated in the price. But if the company reports that instead of $2 per share, it expects to earn only $1, this will be news that sees ABC shares trade lower.

This link between future earnings and present value is fairly evident. But what about interest rates? Let us imagine that certain Federal Reserve statements or changes in the economy (for example, the tightening of the labor market) have prompted the market to expect higher future interest rates. Even though the market received no particular piece of news about the ABC company itself, its stock price will go down. Why? Because the current price represents the present value of all future payments, that is the sum of all payments that the market discounts to the present day. The higher the interest rates, the deeper these payments are discounted. Suppose that annual interest rates are 10 percent. In that case, the present value of $110 paid out in one year is $100. Had the interest rates been higher, for example 20 percent, then the present value of the same $110 would be lower – about $92.

Currently, average market prices are trading at nearly 15 percent below their levels of six months ago. What brought on such a fall: is it tied to company earnings or are interest rates to blame? We know that the economy has slowed, and that some economists even believe that we stand on the threshold of a recession. It would be natural to presume that this drop in prices was caused by lower company earnings. It is somewhat harder to identify the role being played by interest rates. As you know, our central bank, the Federal Reserve, has recently been energetically slashing the short-term interest rates. We once discussed the fact that the relationship between short-term and long-term interest rates is rather ambiguous. But if we look at market data, we find that long-term interest rates have fallen nearly two percent over the past four months (see, for example, yields on 5-year Treasury notes). We just said that lower interest rates should boost stock prices, or at the very least, soften the blow of falling company earnings. Yet for some reason, this is not happening. Why? Let us take things in turn.

Let’s discuss earnings first. As we mentioned a moment ago, prices change when the market receives new information that has not yet been incorporated into the present value. The torrent of information hitting the market in the last three months of 2007 was overwhelmingly negative. Every new forecast slightly lowered the preceding one – and in each case, this represented news that the market had not received before. Thus, each one of these forecasts had a negative effect on market share prices. Q4 2007 earnings forecasts fell by 30 percent as the quarter progressed! Over the same three months, Q1 2008 earnings forecasts dropped by 10 percent. Moreover, first (current) quarter forecasts are still continuing to fall. Today, most economists believe that we will see only minimal growth in the first half of 2008, but that it will accelerate sharply in the third and fourth quarters of the year. How do these changes to the earning forecasts affect stock market prices? As paradoxical is it might seem, they could make very little impact in and of themselves. The fact of the matter is that even though the market is often accused of being shortsighted, it actually looks very far ahead into the future. Earnings over the coming four quarters affect only 10 percent of a share’s price – the rest is determined by future earnings. If one assumes that the recession will be short-lived (and almost all economists agree on this), then lower earnings should only have seen prices drop about five percent. But they fell by 15 percent. That means the problem rests not only in earnings, but also in interest rates.

We will talk about how interest rates affect stock market prices in our next program. This was Sergey Zaks. Thank you for your attention and until next time.