Can the stock market stop worrying about interest rates?
Wall Street's mini-rally last week--even as interest rates surged--suggested that investors don't automatically equate a rate rise with the Apocalypse.
And they shouldn't. History shows that, eventually in the economic cycle, investors stop focusing myopically on rates and pay more attention to corporate profits to justify stock purchases.
Last week, the stock market finished higher despite a broad-based rise in interest rates. The yield on 30-year Treasury bonds, for example, closed at 6.70% on Friday, up from a historic low of 6.54% a week earlier.
Yet the Dow Jones industrial average gained 18.45 points for the week, to 3,546.74 on Friday--within 10 points of its all-time high.
The surge in bond yields followed Federal Reserve Chairman Alan Greenspan's warning to Congress that interest rates don't go down forever. Sounding almost exasperated after listening to legislators' concerns about a turnaround in rates, Greenspan said: "At some point, rates are going to have to move up."
Bond traders seized on his words as an excuse to sell, locking in some of the huge paper profits they've made on bonds as rates have continued to drop this summer.
The much-publicized offerings of 100-year bonds by Walt Disney Co. and Coca-Cola last week also encouraged selling. Many bond market veterans figure that investors' willingness to accept today's yields for the next 100 years is a sure sign that the hunger for bonds has reached frenzy status--and that the next move in yields is up.
But in the stock market, some better than expected quarterly earnings reports from defense, energy, airline and industrial companies seemed of greater interest to investors than rising rates.
For the last 4 1/2 years, of course, falling interest rates provided just about all the fuel the stock market needed.
Three-month T-bill rates have sunk from 9% to 3% in that period, sending millions of savers to stocks in search of better returns.
Given the duration of the rate decline, it's understandable that many investors now assume that Wall Street can't function in any other environment. If falling rates are good for stocks, rising rates must be bad, right?
Wrong. Probably few investors remember, but during 1988 short-term rates rose inexorably all year. And so did the stock market.
Rates on three-month Treasury bills began 1988 around 5.5% and ended the year around 8%. The Dow Jones industrials, meanwhile, gained 12% in that year, recovering nicely from the October, 1987, market crash, despite higher rates.
And 1988 was hardly a fluke. A bullish stock market accompanied rising short-term rates in 1959, 1972 and 1983, among other years.
Stocks and rates advanced together those years for the same reason: The economy was growing briskly, raising the cost of credit but also boosting corporate profits.
On the whole, investors were more excited about profits than they were fearful of higher interest rates. So stocks rose.
Are we at that phase now--where the stock market "decouples" from the bond market?
Many Wall Streeters are dubious, for one major reason: They don't see the economy growing fast enough this year to produce the earnings growth that would make investors ignore interest rates.
Despite some encouraging earnings reports over the last two weeks in selected industries, Goldman, Sachs & Co. investment strategist Steven Einhorn believes second-quarter results overall will be "mildly disappointing."
He had expected the blue-chip companies in the Standard & Poor's 500-stock index to post a 10% gain in operating earnings in the second quarter compared to a year ago. Now, Einhorn says, "I see results being a couple of percentage points below that" because of the economy's ongoing sluggishness.
At the same time, he says, the weak economy also should keep interest rates from rising significantly beyond the current blip up. Though Greenspan is preparing people for higher rates, they aren't coming yet, Einhorn insists.
Indeed, it's hard to imagine the Fed adding to the growing national disaster of the Midwest floods by pushing the cost of credit up, without a very good reason.
"I think the fundamentals of the economy are at odds with what Greenspan has suggested" about rates, Einhorn says.
Thus, his forecast is for more of the same for the next few months: Interest rates trend lower or stay stable at worst, supporting stock prices even though corporate earnings aren't all that great.
Other analysts aren't so sanguine about stocks. David Shulman, strategist at Salomon Bros., worries that the stock and bond markets have already decoupled--but in a bad way.
He points out that while long-term bond yields have plunged this year--far more than predicted--stocks haven't gotten much of a lift from that news. The 30-year T-bond yield has fallen from 7.39% at year's end to 6.70% now, but the S&P; 500 index is up a mere 2.6% this year, Shulman notes.
He believes that the stock market is in part being held back by expectations of another disappointing year for the economy in 1994, as the Clinton Administration's proposed tax hikes kick in, clipping spending and saving.
What's more, he notes, a big chunk of many companies' profit gains this year have come from lower interest expenses, as high-cost corporate debt has been refinanced at much cheaper rates. But the benefit of that savings in year-to-year profit comparisons will dissipate in 1994, unless rates plunge again, Shulman says.
So unless the economy surprises everybody next year, Shulman contends corporate profits won't be strong enough to make investors forget about interest rates. If rates should jump temporarily because of some outside shock--an international event, perhaps--stocks would be vulnerable to a short-term hit, Shulman cautions.
Still, stocks' ability last week to overcome profit-taking in bonds is an important reminder of the next major phase in the market cycle: Investors should increasingly be willing to buy stocks on good earnings news, even if interest rates are rising too. It's happened before; it will happen again.
If the bears are wrong about the economy and corporate profits--and Greenspan is right about higher rates sooner than later--it won't be the end of the world. If history is a guide, it probably won't even be the end of the bull market.
The Windfall from Lower Rates
Many companies are reporting higher second-quarter earnings, thanks partly to lower interest costs, as interest rates have plunged. Here's a look at some of the beneficiaries of lower rates and debt reduction, the savings in their interest bills last quarter versus a year earlier and that savings as a percentage of last quarter's profit. (Most earnings shown here exclude one-time items.)
2nd qtr. Interest savings, profit Chng. vs. year over year: Company (millions) Year ago Amount As % of profit Occidental Petroleum $75.0 +50% $32.0 43% Viacom Inc. 41.6 NA 12.8 31% Dow Chemical 148.0 -23% 41.0 28% Santa Fe Pacific 39.2 +48% 9.8 25% McDonnell Douglas 170.0 +1,445% 40.0 24% Vons Cos. 17.7 +3% 3.7 21% Caterpillar 67.0 NA 13.0 19% Sonat Inc. 26.2 NA 4.1 16% Textron 94.3 +17% 6.8 7%
NA: not applicable (loss in previous year)