The stock market has not performed particularly well this year, up only about 1%. The S&P 500 average closed 1991 at 417, and on Tuesday, it was at 422.92. This has created consternation among two groups of market investors:
* Those who expected that S&P earnings might jump to $23 this year from the $15.97 a share recorded last year.
* Those who feared the economy would falter for a third time in two years, causing earnings to be disappointing.
The groups disagreed on the direction of earnings, but both believed that earnings drive stock prices.
Therefore, they are now perplexed because the stock market is not moving in the direction they think earnings will go.
The fact is, earnings are no the most important factor in stock pricing. The most important factors are money flows second are rate expectations while earnings rank third.
Facts Speak for Themselves
Since most bank executive concentrate on building earnings to improve their stock price, and Wall Street has a large subindustry that does nothing but make earnings estimates, it may seem inane to claim that earnings are a tertiary consideration in stock prices. However, the facts are clear:
* In the 1970s the S&P 500 rose 2.5% per year. Earnings rose much more rapidly - 10.5% annually during that decade - perhaps the fastest growth on record. Clearly, the market and corporate profits were not in sync.
* In the 1980s. stock prices rose 11.4% annually, earnings only 4.1%. Most of the stock price growth occurred in the first part of the decade. when earnings were not expanding. When earnings growth picked up in the later years, stock price growth slowed.
* So far in the 1990s, the stock market has almost completely ignored earnings. The S&P 506 profits fell 30.1% from Dec. 31, 1989, to Dec. 31, 1991, but the S&P stock index rose 19.6%. In 1992, earnings have rebounded significantly and stock prices ave remained flat.
These trends are not merely modern-day phenomena. From 1935 to 1940, S&P earnings grew 29% and stock prices fell 21%. From 1940 to 1945, earnings fell 26% and stock prices rose 64%. Then earnings soared 265% from 1945 to 1949 and stock prices fell 3%.
In 1949, stock prices were at the same level as in 1936, despite the fact that the nation had gone from a depression to a postwar boom.
The explanation for these conflicting movements is that money flows into the sector that is expected to offer the highest immediate profit. When the yield on economic activity is perceived to be high, money flows out of the financial sector and into inventories, receivables, and capital expenditures.
Conversely, when the returns on inventories, receivables, and capital spending falter, funds return to the financial markets. The stock market leads the economy up (or down) because it gets the impact of excess (or depleted) financial flows first.
The Cycle at General Motors
Consider what happens at General Motors through an economic cycle.
When demand for automobiles increases, the company treasurer begins redeeming short-term investments to buy steel, hire labor, and build cars.
As demand continues to grow, GM may actually borrow money in the open market to expand plant facilities. The company goes from being a net provider of funds to a net user.
When the economy weakens, the treasurer reverses course. Funds are withheld from car production, the returns on which have turned negative, and go toward paying off debt. Ultimately they are used to buy securities. GM has become a net provider of funds.
Weak Economy Helps Stocks
By making rational judgments on expected returns, the corporate treasurer moves funds into and out of the financial markets. Thus, bond and stock prices do better when the economy is weak and there is no competition for funds.
For reasons that have seemed to make little sense, securities markets usually do very poorly from September to November, and very well in January and February. This is also due to the fact that the economy is the dog that wags the financial sector tail.
From 1926 to 1991, the stock market rose 4.7% a year. Dividend yields throughout this period averaged 4.4%, so the total return on equity investments was slightly over 9%.
Despite the fact that stock prices have been on a long-term uptrend, sequential monthly performance figures (this time going back to 1900) indicate that the market has generally declined in the months of September and October.
Ten of the 15 worst declines on record occurred between September and November, and seven of these were in October, including the crashes of 1929 and 1987.
Conversely, the stock market has performed well in January and July. In the past 91 years, stock markets in the first quarter have consistently outperformed those of the September-November period.
Similarly the market action in the spring has been dismal relative to that in the summer. Established trends of this nature cannot be dismissed as statistical flukes.
Consumers Play Big Role
When viewing the economy as the primary user of funds, and the financial sector as a residual user of funds, the seasonal activity of the stock market is explainable. The United States is predominantly a consumer economy. In the fourth quarter of each year, climaxed by the holiday season, retail sales almost equal expenditures in the previous three quarters.
Treasurers of companies like Sears and its suppliers must marshal all the cash they can in September and October to placed inventory in stores for the peak holiday season.
At that time of year, the return on money invested in an economic activity - inventories - is perceived to be better than that from financial investment.
Back to Financial Markets
Conversely, in January, Sears' treasurer has a different outlook. Because the inventory has, ideally, been sold, there is plentiful cash to be invested in financial instruments. In January, the relative return on inventory investments is not expected to be attractive.
The retailers' seasonal impact on the financial markets was mirrored earlier this century in the agricultural sector. From 1865 to 1945, the United States was primarily a farm economy, and cash demands were highest in the planting season.
Fragmentary stock prices gathered from that era, mostly from the 20th-century, indicate that May was the worst month for stocks, not October.
In the latter half of the 19th century, it was well understood that when the harvest failed, a cash drain would occur in September, because farmers would not be paying their debts. The depressions of 1873, 1883, 1893, and, to a lesser extent, 1907 reflected such money panics.
Suppliers Flush with Cash
The summer rallies in this period might have been due to the buildup of cash in farm suppliers' accounts. The summer rallies of today may reflect the partial closing of production, and attendant reduction in cash needs, reflecting the summer holidays.
A second explanation for why stocks do poorly in strong economies is that as perceived rates of return rise in the economy, the yields on common stocks must also rise, which can lower the stocks' prices.
Investors in common stocks expect some base rate of return, which generally must be higher than what is available on risk-free investments such as Treasury securities.
There is no precise method for determining the expected base rate at any given time, but intermediate Treasury debt - six- to nine-year maturities - seems to be a good proxy.
The average S&P 500 return on equity for the past 15 years has been 13.4%. This suggests that an average corporation is repaid its initial investment in 7.5 years, or at the same point as the average maturity of the intermediate Treasuries.
While there is no precise relationship between the earnings yields on common stocks (reciprocal of the price-earnings multiple) and the yield on the intermediate Treasuries (expected base rate), the relationship between the two numbers is reasonably strong.
They rarely move in opposite directions, and evidence suggests that the magnitude of change in the two numbers will ultimately come into balance, even though there are demonstrable leads and lags.
Therefore, there is considerable justification for using the reciprocal of the intermediate-maturity Treasury bond rate as an indicator of where the multiple on common stocks should be. Currently, the average bond yield is 6.03%, implying a stock market price-earnings multiple 1/6.03, or 16.6.
The S&P 500 is now selling at 422.92. From July 1992 to July 1993, this broad group of companies is expected to earn $25.50 a share. Thus, the current multiple on the S&P 500 is 16.6 times projected 12-month earnings.
The current close relationship between the two numbers may be serendipitous. Earnings expectations for the S&P 500, or the risk assumption in the intermediate bond, may be incorrect.
In 1991, no expert was remotely close in projecting the S&P 500's earnings because of a very disappointing fourth quarter, and most economists have failed to correctly interpret bond yields for decades.
However, empirical evidence supports the theory posited here, that, over time, these two numbers will remain closely related.
In the next column, I will explore how these concepts -relate to the actual selection of common stocks.