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Brian Andrew, CFA

Bricks in the Wall of Worry

Investors are a fickle bunch. Here we are, facing a year of potential record earnings and all‐time high profit margins, and stock investors are nervous. It is said that those investors climb a “wall of worry” when bidding stock prices higher. The key bricks in that wall now appear to be economic growth, inflation, interest rates and geo‐politics. Let's try to shed some light on each of these and how investors are viewing them.

A Stock's Price

The wall of worry may fundamentally have to do with how one arrives at a stock's price. A stock investor must estimate future earnings and discount them at a rate equal to the risk‐free rate plus a “risk premium.” The risk‐free rate is usually a 90‐day Treasury bill yield (because we assume that the U.S. government will still be solvent in 90 days). The risk premium represents the minimum return a stock investor is expecting over the life of their investment. Think of it as the return you want for giving your money over to a company's management team for a long period of time. Future earnings are estimated based on a company's past performance and projected rate of growth. That growth can be impacted by a lot of things out of the company's control, such as fiscal policy, labor markets, cost of raw materials, tax policy and much more.

Earnings and the risk premium can be difficult to determine. In other words, most of the formula for determining a stock's price is unknown, estimated or guesstimated! This explains why a lot of other news about politics, the economy, interest rates and fiscal policy move stock prices each day.

Which Bricks

Knowing which bricks in the wall matter and which don't is important. Some are foundational, and a disturbance there matters. Some represent a fraction of a course and don't matter much.

On any given day, there is good and bad news that may alter investors' views regarding future corporate earnings estimates, the lynchpin of that stock price formula. Most often, there are themes to the kind of news investors are focused on. Those things mentioned earlier – economic growth, inflation, interest rates and geo‐politics – all seem to be the key themes we're focused on, so let's review each in more detail.

Economic Growth

We are entering the tenth year of an economic expansionary cycle. Last week, we received a look at how the economy performed during the first quarter. Real growth was up 2.3%, not much better than the five‐year average and lower than the two quarters before, which were closer to 3%, the growth rate investors are hoping for in 2018. While first quarters have been weaker, some wonder if this means we won't reach 3%.

Three forms of stimulus suggest otherwise. First, tax reform. Corporations will receive a $180 billion benefit in 2018 from tax reform. While some of this money will go to repurchase stock, reduce debt or increase wages, some will go toward business investment. That's the second form of stimulus. Business investment represents what companies invest in themselves, including new machines, improved productivity or real estate to house more of what they do. Last year, business investment grew by $2.7 trillion. This year, it is expected to grow by 7 to 10% more, partially due to tax reform. This could add another $190 to $270 billion to investment in 2018. The third form of stimulus is the $200 billion increase in the Federal government's budget. This additional spending will come in the form of defense and discretionary spending. Combined, this is additional stimulus equal to 3.2% of our economy – an amount likely to prolong the growth cycle, although not indefinitely.

Inflation and Interest Rates

Of course with this much stimulus, investors are bound to worry about the effect it may have on inflation. Inflation is a problem for many reasons but most important to stock investors is that it creates the likelihood of higher interest rates. Therefore it raises both the risk‐free rate and risk premium they demand. The higher those rates, the bigger the discount rate on those future earnings. Some simple math:*

  • If a company earns $5 per share, 90‐day T‐bills are at 1.5% and the risk premium is 6%, then the value of those earnings is $66. ($5/1.5%+6%)
  • If interest rates rise and those 90‐day T‐bills are now at 2.5% and investors are more worried about risk so the risk premium rises to 7%, then those earnings are worth less, $53. ($5/2.5%+7%)
  • *Stock investors use several methods to determine the value of a company's stock. The example provided here is a simplification of the discounted cash flow method excluding a future earnings growth rate. This link provides a more detailed view of the formula.

So, the thinking goes, if inflation goes up and interest rates go up, then stock prices could decline.

As the economy's growth rate has stabilized, the interest rate policy‐making Federal Reserve has decided that it doesn't need to keep capital so cheap. As a result, it began raising interest rates in December of 2015 when the Fed Funds rate was 0%. It continued with another .25% hike in March of 2018, and that rate now stands at 1.5%. Now that it seems as though the economy could achieve a 3% growth rate, investors worry that the Fed will want to stave off any potential inflation acceleration and raise rates more frequently.

However, the Fed's own models recognize that, despite all the stimulus mentioned and the tight labor market, inflation is still moving higher at a slow rate. We think that might be because of some unusual structural forces such as growing e‐commerce and demographics. Both are very large, so the cyclical force of the aforementioned stimulus might not be able to overcome them entirely.

Geo‐politics

Perhaps the most troubling brick of all is when the level of uncertainty rises. Whether it is populism and politics in Europe, power grabbing in China, political unrest in oil producing countries, or regulatory policy, geo‐politics weighs on the minds of stock investors. Because they are trying to determine how those future earnings will grow, anything that could upset the scenario they've painted creates uncertainty and in turn raises the risk premium. Fortunately for worriers, there is no shortage of geo‐political issues each day.

Trade tariffs and talks are the most recent example. Discussions of tariffs and potential for a change in the trade deals struck with countries we import products from and export them to have the potential to impact businesses and their future earnings. However, this is usually specific to companies and industries and shouldn't affect the market overall (yet sometimes does).

Understanding how these key bricks may be affected and considering the outcome for stocks are what we do every day. When the wall of worry grows higher, it is up to us to determine whether or not those bricks matter. The wall is always there. Sometimes, scaling it is the most difficult when the best opportunities present themselves.

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Views and comments expressed in this blog are those of the author and do not necessarily represent the positions of Cleary Gull or fellow Cleary Gull associates.