There are many factors that come into play when trying to value stock markets.
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Arguably, the two biggest factors are the future earnings of the collective stock market index and, of course, interest rates.
The first factor is pretty self-evident. The larger the collective earnings for stocks within an index the higher the valuation of the stock market as a whole. Of course, the opposite applies, as collective earnings fall for companies, so will the value of stock market.
The second biggest factor affecting stock market valuations is the level of interest rates. As interest rates fall, the value of stocks generally rises and as interest rates rise, the value of stocks generally falls. This has to do with a mathematical model that is most widely used by Wall Street analysts to value stocks. In essence, the model computes that as rates fall, the present value of a stock market’s earnings results in a higher valuation for stocks and vice versa.
So why does all this matter?
If we look at the situation today in financial markets we have an interesting development that we have not seen for several years. Corporate profits have steadily risen since the heart of the pandemic and have arguably reached a pinnacle in this current cycle. From here on in, given the dramatic rise in inflation, the cost of doing business for most companies within the stock market have risen.
This means, in order to maintain future earnings growth, companies within the stock market must either sell more goods and/or services, (not likely given the very strong upsurge in current demand by consumers as well as the supply constraints most companies are currently dealing with, which is likely to lead to more stock outs of inventory than it is to increased sales) or maintain profit margins by increasing prices thereby offsetting the higher cost of doing business.
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This peak in earnings is occurring at a time when central banks around the world are increasing interest rates to combat inflation.
The situation above potentially sets up an environment where companies, and thus stock market valuations, are left between a “rock and a hard place,” as it relates to stock valuations. If companies do not raise prices, their margins will be squeezed, causing earnings to fall and thus valuations to fall as well.
If companies choose to raise prices, their volume sales may fall if their product or service is deemed non-essential by consumers. This in turn would cause profits to fall in the aggregate as fewer items at the higher price would be sold.
Conversely, on essential items and services, (where consumers have no choice but to continue buying – the so-called consumer staples) increased company costs can be passed on to consumers by way of higher prices in order to maintain margins.
However, given central banks have now shifted their focus to fighting inflation, if companies increase prices, it would also cause inflation to rise even more than is currently the case.
This in turn, may force central banks to raise interest rates higher than would otherwise have been the case, in an effort to fight off an even worse inflation problem, as a result of the higher price increases by companies.
Therefore, though earnings would be maintained if companies raise prices, valuations for stocks may fall nonetheless, due to the higher interest rates that central banks would no doubt deploy to fight an even worse inflation problem. This higher interest rate in turn would cause stock market values to fall in the Wall Street stock market valuation model.
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The only potential savior in the scenario above would be if central banks soften their stance on fighting inflation and don’t raise interest rates as high as what is expected. This would then allow stock market valuations in aggregate room to advance further.
Over the next several months the stock market will face its biggest challenge yet, in this current cycle as rates rise and profit margins are at risk of shrinking. Stay tuned as the year unfolds.
Mike Candeloro, senior portfolio manager and wealth advisor with RBC Dominion Securities and the head of The Mike Candeloro Wealth Management Group supplied this article. RBC Dominion Securities Inc. and Royal Bank of Canada are separate corporate entities, which are affiliated. Member CIPF. Mike can be reached at www.michaelcandeloro.com or message him at [email protected] or on LinkedIn.