Sunday, January 29, 2006
Cause and Effect: Stock Market Physics (Part III)
Changes in interest rates by the RBI, as seen in Part II, have an effect on stock valuations and the economy. It affects valuations directly (by increasing the risk-free rate of return) and indirectly (by changing the investor's expectations of future earnings growth). What creates the need to hike interest rates? curbing inflation is the dominant reason.
Cheap money
Inflation is, simply, too much money chasing too few goods. In times of low interest rates and high economic growth, the economy is awash with money. The production of goods, however, does not keep up leading to a mismatch between supply and demand. With all that money, people are willing to pay more for the same thing. Rather than things getting more expensive, it helps to look at inflation as money getting cheaper. Put another way, inflation reduces the purchasing power of money.
The real rate of return
How much the rupees you have can buy is more important than how many rupees you have. Nominal return is what you think you're gaining on your investment. If you made an investment at Rs.100 which is worth Rs.120 after one year, your nominal rate of return is 20%. The real rate of return is the return on an investment after inflation and taxes (if any). If inflation was at 5%, your real rate of return is 15% in the above example. A positive real return indicates that you have greater purchasing power than when you started. When your nominal rate of return is less than inflation, you're losing real money. Your money now will get you less than what it used to.
Inflation and stock valuations
It seems logical to postulate that inflation should leave a company's earnings (and therefore, its valuation) unchanged. After all, inflation of x% would cause an increase of x% of prices of products. This, in turn, should increase the nominal earnings by x%, leaving the company's earnings unchanged in real terms. The key assumption here is, of course, that a company can increase the price of its products at the same rate as inflation. The ability to pass on increased costs to the customer is not that easy, especially in competitive industries that are volume-driven. The effect of inflation on the profitability and growth of a business is highly dependent on the business itself. Companies that can pass on their increased costs to customers have the upper hand in times of increased inflation.
Forget inflation's secondary effects for the moment. Should inflation, by itself, cause investors to look for returns marked up the increased rate of inflation? There should be a change in expected nominal return to preserve the investor's real rate of return. If a company can pass on costs to customers, its valuation should remain unchanged as the nominal growth rate has kept up with inflation. If the company cannot increase nominal growth in line with inflation, its valuation should fall to reflect the decreased real return rate.
There is another effect at work during inflation. Since fixed-income instruments have no protection against inflation, the fixed payout of a bond is worth less in real terms with each sucessive year. There is a belief that stocks are an effective hedge against inflation and the increased demand for stocks would increase stock valuations. As noted before, an individual company may or may not outrun inflation. Second, too much inflation causes a cycle of lower consumer spending and lower economic growth called stagflation. Stocks are not a guaranteed hedge against inflation but they work at most times. Guaranteed hedges are inflation-indexed bonds that change their yield to reflect inflation.
Increasing inflation will also lead to rising interest rates. The RBI, to keep inflation under check, will increase interest rates. Why? rising interest rates makes money more expensive mirroring the rise in prices. Then, as explained in Part II, stock valuations will fall.
GDP and corporate profits
GDP or Gross Domestic Product is the total value of final goods produced in a country in one year. There are two kinds of GDP. Nominal GDP is the monetary value of final goods produced. Real GDP is nominal GDP minus inflation. Growth in GDP is the subject of much speculation as it provides information of where the economy is heading: are we slowing or accelerating? Besides, GDP growth rate provides the limiting factor of corporate profit growth. One company cannot grow faster than the economy does forever. Corporate profits is one component of GDP. Assuming a constant corporate-profit to GDP ratio, it could be said that average corporate profits would grow at the same rate as nominal GDP. Economic data shows that corporate profits tends to a constant percentage of GDP. Note that this 'big-picture' view does not preclude sectors or companies growing faster than the economy for short lengths of time.
GDP and valuations
Nominal GDP growth, if used as the yardstick for growth for corporate profits, can be used to define if markets are overvalued. If the weighted P/E ratio of stock market indices anticipate a faster growth rate than the nominal GDP, they are going to be disappointed. But when it comes to individual companies, we face complications. How does a change in GDP growth affect company X in a quantitative manner? Some industries such as steel are closely linked to GDP and their growth can be more or less had from GDP growth. For some other companies, you can use a slightly different model. First, find the source of revenue, its percentage of consumption expense and the trend in percentage change. For example, to link soft drinks to GDP, a very simple method would be:
- Find out the expenditure on soft drinks as a percentage of household consumption
- Find out if soft drinks is an increasing or decreasing percentage of household consumption
- Project the future percentage of expenditure on soft drinks
- multiply it by nominal GDP to get projected growth of the soft drink industry
As you can see, nominal GDP underlies earnings expectations. Revisions of GDP growth will affect anticipated earnings growth which,in turn, will change stock valuations.
History repeats itself
We have seen three important macro-economic variables (interest rates, inflation and GDP) and their effect on stock valuations. How do these three tie in together? consider an economic cycle that ties them all together with the market in cause-and-effect style:
- Low interest rates
- High GDP growth (cheap money, more spending)
- Bull market (optimists unite!)
- Increased money(excess liquidity)
- Inflation rises ( more money, less goods)
- High interest rates (money is now more expensive, courtesy the RBI)
- Low corporate profits and growth (margin squeeze, less spending)
- Bear market (people get out of stocks)
- Interest rates lowered (stimulate economic growth)
- Go back to 1.
