We got plenty of strong financial results this week from some of the world's big names — including Hewlett-Packard, Home Depot and Applied Materials — but the major stock markets responded with a collective shrug. The indexes had a nice rally going on most of Wednesday, but by the end of the day it had all evaporated and the bulk of the week's market action was lacklustre at best.
Record high oil prices were obviously a factor and a crude spike caused the disappearance of Wednesday's rally. Another culprit — one that is tied to the spectre of rising interest rates that continues to hover over the economy — may also be behind the markets' moribund behaviour. It goes by the name of "multiple compression."
Simply put, it means that rising rates tend to push down the price-earnings multiple that investors are willing to pay for stocks, even if — and this is a crucial point — profits continue to climb. That could explain why the market's response to a steady stream of strong profits has been so profoundly underwhelming. And it's not just stocks with high price-earnings multiples such as Yahoo or eBay that get hit. All stocks are affected, although the first casualties are usually the nosebleed stocks.
Since the beginning of April, the Dow Jones industrial average has slumped about 5 per cent, and the Nasdaq market index has tumbled about 8 per cent. And yet, profits have been higher, more robust than even optimistic analysts were expecting. On average, profits for Standard & Poor's 500 index companies were up over 25 per cent in the first quarter from last year's first quarter. However — and this is the telltale point — the S&P index is also trading at about 20 times earnings, when the average for the past 50 years is just 16.
The market's lacklustre response is in part a sign that investors have already discounted strong profits — that is, paid for them in advance. It may also be a sign that they aren't willing to pay as much for those profits now. Instead of paying 130 times profits for Yahoo, for example, they may only want to pay 100 times. That would sink Yahoo's stock by about 25 per cent. And even if its profit rises, multiple compression means that its stock price could still fall.
Here's why rising interest rates lead to this phenomenon of multiple compression: For one thing, the current value of future profits, the stream of income investors are theoretically buying, falls as rates rise. Stocks also become less attractive relative to bonds when bond yields rise. Take Intel: The world's largest chip maker is trading at 28 times its share profit. If you flip that ratio around, you get a "yield" of about 3.5 per cent. Benchmark 30-year U.S. Treasury bills are yielding about 5.4 per cent. Which would you rather invest in?
From 1994 to 1995, when the Fed boosted its lending rate from 3 per cent to 6 per cent, the major markets went nowhere, even though profits were rising. True, those rate hikes came faster than economists are expecting to happen this time around, so the effect of multiple compression may be less pronounced. But it will occur just the same. Merrill Lynch chief economist David Rosenberg says 70 per cent of the market's rise between 1980 and 2000 came not from profit growth but from higher price-earnings ratios — in other words, multiple expansion. What happens when the reverse occurs?
Mr. Rosenberg says market multiples tend to contract by two or three points during a period of rate hikes. If the S&P 500 were to move to a 17 or 18 times multiple, it would fall by 10 to 15 per cent from where it is now. The bulls point out that interest rates are rising because the economy is growing, which is good for profits. But if investors aren't willing to pay as much for those profits, the markets could continue to struggle.
© The Globe and Mail
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