Zaks Investment Advisory Service

What Determines Stock Price Levels? Part II.

Last time, we tried to answer a seemingly simple but fundamentally important question: what determines stock price levels? At the same time, we also tried to establish why stock prices continue to languish at such low levels. I noted that two factors determine prices levels: future earnings and future interest rates. We analyzed the changes in earnings in the US companies witnessed in the recent months, and concluded that even though their decline has caused price levels to drop somewhat, this may only explain about a third of the actual fall. For this reason, we came to the conclusion that most likely, the main culprit here is interest rates.

I would like to once again remind you that stock prices go up when interest rates go down, and fall when interest rates rise. This happens because their present value represents the sum of future payments that the market discounts to the present day. The higher the interest rates, the bigger the discount and, consequently, the lower the price of the stock.

I once noted that interest rates (or the rates of return sought by investors) have two components: the first compensates investors for the loss of purchasing power caused by inflation, while the second is the interest investors demand as part of their real return and risk compensation. There are numerous types of bonds on the market: some, like Treasuries, carry no default risk, while other federal bonds even compensate for inflation. These are called TIPS (Treasury Inflation-Protected Securities) – accordingly, they have the lowest yields of all. On the other hand, when investors purchase corporate bonds, they demand additional compensation on the off chance that a company might go bankrupt and never return the money (the so-called “risk premium”). As a result, corporate bond yields are always higher than those of federal bonds with the same maturity periods. Just to clarify: when I say that Treasuries are “risk-free” instruments, what I mean is that they carry no risk of default. Of course, all bonds are still subject to interest rate risk.

Of these two components of interest rates, inflation should not worry us too much, even though several recent signs have emerged suggesting that it could grow. For example, inflation as measured by the producer price index has risen slightly. Inflation has also gained force in China, which supplies a vast amount of our consumer staples. But the market believes that inflation will remain low. How do we know this? The spread in yields between regular federal bonds and TIPS gives us a sense of how the market prices future inflation risk. You may find a chart tracking the inflation component of rates in the Market Notes section of our site: it has remained almost constant over the past 12 months.

But risk is something else entirely. We constantly hear about how credit risk spreads to various other financial instruments. We may confirm this by looking at the so-called “high yield bonds.” These are risky corporate bonds: they are issued by companies with more precarious financial standing. Very often, investors who hold these bonds find themselves at the very bottom of the payment hierarchy. Consequently, these investors demand extra compensation in the shape of a risk premium – which is why these instruments are called “high yield bonds.” The component representing compensation paid for the risk of holding high yield bonds has been falling until June 2007, when it reached about three percent . In historical terms, this is a very small premium. It meant that investors decided that all was well in the financial world, and that the possibility of such unpleasant developments as bankruptcy was very low. In June, everything changed: the risk component began growing by the day. This coincided with the start of the mortgage-backed securities crisis. The corporate bonds of industrial companies are not directly linked to mortgage-backed securities. But changes in one sector forced investors to reappraise the risk levels of many other financial instruments. Currently, the risk premium stands at almost nine percent! Investors now feel that the less risky corporate bonds are also riskier than they once were, even if to a lesser extent than the high yield bonds (you may also find these charts on our site).

How has this development affected stock prices? I mentioned that the present value of a stock represents the sum of future payments that the market discounts to the present day. I also noted that the higher the interest rates, the bigger the discount and consequently, the lower the price. As we just saw, implied market interest rates have risen sharply in recent months. The fact that yields of risk-free instruments such as Treasury bonds have fallen can in no way assist the market. Look at the chart comparing high-yield spreads and that of the S&P 500 index. They are almost mirror images of each other: when one curve goes up, the other goes down, and the reverse.

We have now examined two factors – future earnings and interest rates – and came to the conclusion that of the two, the real growth of interest rates which followed increases in risk premium has had the greater affect. In a certain sense, this is a comforting conclusion: the Federal Reserve may affect the perception of risk more (and faster) than it may influence future company earnings. I believe that if the Federal Reserve continues to pursue its policy of reducing the short-term interest rates (and all signs point to the Federal Reserve cutting rates by another 50 basis points on March 18), this may calm the market and lower the risk premium. And this, as we have just seen, may lead to higher stock price levels.

And with this, we will draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.