Stock prices reflect the constant struggle between expected interest rates, expected earnings and expected changes in risk premiums. It’s that simple. Most bulls know that the economy is slowing but they’re buying stocks because they believe that we’ll have a soft landing – thus their bet is that earnings will hold up o.k., but interest rates will decline and therefore that valuations will increase. The bears, on the other hand, believe that even if interest rates decline (as they will in a slowdown), that the decline in earnings will more than offset the decline in interest rates and thus valuations will fall.
To use an overly simplistic example, let’s say the market is represented by a single Stock A. EPS for Stock A will be $1.00 this year and are discounted at 7.5% (which reflects current long-term interest rates, earnings growth and a risk premium). The value of Stock A today is $13.33 ($1.00/7.5%).
The bulls believe that next year’s EPS for Stock A will be $1.06, long-term interest rates will decline by 50 bps and the risk-premium will remain steady, yielding a discount rate of 7%. So, they believe Stock A will be worth $15.14 next year.
The bears believe that next year’s EPS for Stock A will be $0.85, long-term interest rates will fall by 75 bps and the risk-premium will remain steady, yielding a discount rate of 6.75%. So, they believe Stock A will be worth $12.59 next year.
Again, this is an overly simplistic example, but my point is that the challenge for the bears (and I’m one) is that EVEN IF earnings stay flat or decline, the decline in interest rates may overwhelm the impact of reduced earnings from a present value standpoint – not even considering the issue of the risk premium – and stocks could go up. Interest rates and earnings are like a seesaw with the risk premium sliding around in the middle. You have to get at least two of the three right and even then sometimes the third overwhelms the other two. It ain’t easy.
I made a long post a while back regarding efficient markets that I thought explained the theories fairly succinctly. I guess I was wrong. I’m too lazy to go over it again, but the key issue is not to focus on “right” and “wrong” but rather “biased” and “unbiased.”
