Profits, Rates Still Key to Stocks

The market for common stocks has been a major topic in the news. The gyrations have been enormous. This may be an appropriate time to take a look at the future economy with the market in mind, assuming that can be done. As you may know, there are many weird and wonderful ways of looking at the stock market. The best stock market forecasters are pretty darn close to psychic with respect to their sense of timing and their nose for value. Economists tend to need too many facts.

Presumably, the two key elements that drive stock prices are profits and interest rates. You might say the former pushes up stock prices and the latter, translated into price/earnings ratios, pulls them up. Get those two factors right and you can forecast stock prices.

But can you think of two economic variables that are more difficult to forecast or that have larger error potentials? And even if we got them right, we’d be frustrated by the variable leads and lags between these factors and stock price movements; i.e., we’d probably be bankrupt before we were proven right. But I’m going to try, anyway.

First, what are the short-term prospects for the key variables--profits and interest rates--and what do they suggest for the market over the next six months or so?

Earnings momentum definitely has slowed since late 1984, and we seem to be having a terrible time getting a fix on the true path of profits; e.g., the earnings for the Standard & Poor’s 500. Sadly, my own estimate for 1986 earnings, which started out at $17.50, has now shrunk to $15.00, and the year is not over yet. My only consolation is that I have plenty of company.

Decline in Interest Rates Not Over

Anyway, my first-pass estimate for next year is the same: $17.50. One of these years I’m bound to be right.

I wouldn’t even begin to tell you about my record forecasting the other key variable in stock prices: long-term interest rates. I think you can figure that out for yourself.

Long-term Treasury bond rates now are running about 8%, up from about 7.5% a few weeks ago. But I don’t think the decline in rates is over yet. The economy shows no clear evidence of breaking out of its 2% straitjacket, and the Federal Reserve will keep on accommodating the credit markets until the economic pickup is clear to all. But since we don’t know how to forecast interest rates, let’s just assume that long Treasuries will be at 8% to 8.5% by mid-1987.

The stock market has to compete with alternatives available in the bond market. Thus, it’s not surprising that there’s a close connection between bond yields and P/E ratios on stocks.

The P/E ratio implied by our interest rate guess, (12 to 12.5 times earning), when combined with an earnings estimate of $17.50 for next year, suggests that present stock prices are fairly fully priced. The market over the past year has been pulled up exclusively by declining interest rates (and, consequently, rising P/E ratios). It certainly has not been pushed up by earnings growth!

Thus, as soon as it appears that interest rates may have bottomed out (P/E ratios topped out), you see a whole lot more attention being paid to earnings potential. And if the long-awaited economic pickup doesn’t materialize, the earnings potential may not be there. I think it will, but it certainly would be nice to see some hard evidence soon.

So the short-term view of the market is not much upside potential unless the economy gets a lot stronger and--not or--interest rates continue to decline next year, an unlikely combination.

Now, there’s another longer-range politico/economic way of looking at the market. I refer here to the presidential economic cycle. Presidents tend to do different things at different stages of their terms, with markedly different results for the stock market.

In postwar history, we have had eight bona fide recessions. Six of those eight recessions were under Republicans, and five of those were under way by the end of the first half of the President’s term. Let me put it another way: You always get a recession in the first half of a Republican’s term, and it has been that way with all Republicans back to and including Herbert Hoover. On the other hand, under Democrats you never get a recession in the first half of the term. Interesting!

Volatility of Market

While there is a wide disparity between Republicans and Democrats in terms of what happens to the economy in the first half of a President’s term, curiously enough, the stock market tends to do very little in the first half of any President’s term. Of course, within that two-year period there can be tremendous volatility--more volatility than at any other time in the presidential term--so that if you’re in the market, you would hardly characterize the market as “doing nothing.” But that’s the way it tends to work out over the full two-year period.

The S&P; 500 index so far in the third quarter is running a whopping 47% above where it was at the beginning of Reagan’s second term, clearly an anomaly compared to almost any past President’s first two years. Is it because President Reagan this time is going to break the pattern of recessions in the first half of all Republican Administrations? It appears likely.

If so, it has never happened before. Interesting! Do you suppose it’s because his policy actions, particularly the huge budget deficits, are more like those of a Democrat, or what? In any case, from this point of view as well, the market appears a bit overblown relative to past history. But, if we don’t have a market correction soon, then we may have made it through the toughest period for the equity markets relative to the four-year presidential economic cycle.

The reason for this is that, after the midpoint of a President’s term, it hasn’t seemed to make much difference to the economy which party was in the White House. We tend to get good economic results from either party, and we never have recessions--well, almost never. And, as you might expect, regardless of party, the market tends to go up strongly, more than 30%, in the second half of a President’s term. To tell you how representative that number is, seven out of nine times in postwar history, the gain ranged between 27% and 48%.

Next year, as policy begins to focus more intensively on the 1988 elections, the risks for the markets should be progressively lower. One might almost say it’s now or never for market weakness; i.e., if we don’t get a market correction in the next few months, chances are we won’t have one through 1988--if past is prologue.