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Jubak's Journal
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Will the Dow hit 11,000? Ask the Fed
It all depends on which rises faster, earnings or interest rates. I dont see the Fed raising rates before mid-2004. Then things get interesting.
By Jim Jubak
The Dow Jones Industrial Average is making a run at 10,000 again. So where do we go from here?
Look to interest rates for the answer. And the interest-rate picture says that stocks should continue to have the wind at their backs through the first half of 2004. The going will get much tougher, though, in the second half of the year.
The Dow last blasted through the 10,000 level in late February 2002. If the stock market cracks that barrier in the next few days or weeks, will it be on the way to 11,000 or higher? Or will investors see the market stall, as it did in 2002, bottoming near 7,300 in October?
Clearly the economy will play a big role in deciding if stocks move up from here. The recovery certainly looks strong enough on the current numbers to keep the rally going. Nobody expects GDP growth in the fourth quarter to match the 7.2% from the third quarter. But add that bullish number to the good news on productivity in the same period and the odds are the economy will be on roll again through the first half of 2004. In the third quarter, productivity (a measure of the increase in the value of a workers output for an hour of work) grew by annualized 8.1%. That followed a 7% increase in the second quarter, according to the U.S. Labor Department. The economy created 126,000 new jobs in October, the government estimated, about twice what economists expected.
A jump in rates means kissing Dow 11,000 goodbye
But theres still one thing that could derail the stock market even if the economy keeps growing: higher interest rates. If interest rates go up sooner and more rapidly than investors now expect, that could put the kibosh on Dow 11,000 faster than you can say Alan Greenspan.
There are a few worrisome signs on the interest rate front. On Nov. 5, the Reserve Bank of Australia increased short-term interest rates by 25 basis points to 5%, becoming the first major central bank to start raising rates. (100 basis points equal one percentage point.) In 2001, the Reserve Bank cut rates six times in 11 months to get the economy rolling again. Now with the economy hitting on all cylinders -- Australia has produced about 250,000 new jobs in the last year, about equal to the population of Canberra, the national capital -- the central bank has decided to take its foot off the gas. The financial markets in Australia are currently projecting two or three more 25-basis-point rate hikes before the end of 2004.
The Bank of England followed suit just a day later, raising its benchmark short-term rate 25 basis points to 3.75%. The increase -- the first in British interest rates since February 2000 -- was widely expected. The economy in the United Kingdom has been far stronger than in either the euro zone or the United States. More people are working there than at any time during the last 25 years; British unemployment is just 5%. Inflation has become increasingly worrisome, though. Housing prices in October rose at an annualized rate of 16%. The London financial houses are currently expecting the Bank of England to raise rates to around 5% by the end of 2004.
Will the Fed follow the British?
Is the U.S. Federal Reserve about to follow suit? The prospect worries enough people on Wall Street that Greenspan directly addressed the issue in a speech via satellite to a meeting of the Securities Industry Association.
Of course, Greenspan being Greenspan, it isnt clear exactly what message the financial markets were supposed to take away from his remarks. The Fed has been assuring Wall Street that short-term rates will stay low for a considerable period. In his Nov. 6 comment, Greenspan said that although the economy has clearly accelerated, inflation at recent lows of just 1% continues to meet the Fed's goals for stable prices. With productivity growing at such a fast rate, monetary policy at the Fed can be more patient than in previous economic expansions. In other words, the Fed wont raise rates until it sees evidence of actual inflation.
When will that occur? Prices in the Fed Funds futures market suggest there will be no rate increase until May 2004.
If rates rise, corporate earnings must rise faster
Interest rates are so important to stock investors because as interest rates on Treasury bills climb, stocks have to deliver a higher return to keep up. The usual result: Stock prices fall.
Consider Intel (INTC, news, msgs). Some investors may be perfectly happy holding it at $34.12 (its Thursday close) because they believe the stock will climb to $38 during the coming year. That translates into a potential return of 11% over that period. They hold Intel because that potential return looks so much better than the recent 4.4% yield on 10-year Treasury notes. They recognize that shares of Intel stock are more risky than Treasury notes in most markets, but the extra potential return from owning Intel makes the extra risk worth it. (You can check out the 10-year yield here.)
Some of those Intel owners would have second thoughts about that preference, however, if the yield on a Treasury were 7%. Or 8%. Those investors would need a higher potential return from the riskier Intel to make up for the higher yield on Treasurys. And that means the price of Intel shares would fall until the difference between the current price and the target price of $38 was enough to produce the higher return investors demand to keep pace with higher Treasury yields.
How big an effect would rising interest rates have on the stock market as a whole?
You can ballpark that effect with a valuation model that compares the forward price-to-earnings ratio of the stock market with the inverse of the yield on the 10-year Treasury note. Market history shows that theres a pretty good relationship between what investors are willing to pay for the stock markets earnings per share for the next four quarters and the inverse of the yield on the 10-year Treasury.
So for example, the forward price-to-earnings ratio on the Standard and Poors 500 stock index ($INX) membership was about 17.7 at a recent index price of 1,050, according to First Call. On Oct. 31, the yield on a 10-year Treasury note was 4.29%. The inverse of that yield (that is, 100/4.29) comes to 23.3. So according to this method, with these projected earnings and this interest rate, the market is undervalued since stocks should trade at a price-to-earnings ratio of 23.3 but actually trade at a P/E of just 17.7.
By Nov. 6, however, the yield on a 10-year Treasury note climbed to 4.42%. The inverse of that is a lower 22.6. Stocks are still undervalued, according to this method, but theyre undervalued by three percentage points less than they were a week ago.
The 10-year Treasury yield would have to jump 1.2 percentage points to 5.65% before all the undervaluation was wiped out and stocks were fairly valued.
That assumes future earnings dont increase. But what if it takes until the end of 2004 for interest rates to climb to 5.65%? By that point, future earnings would be higher, and the forward price-to-earnings ratio lower. That would give stock prices room to continue their climb.
The race between rates and earnings
So it all depends on how fast interest rates and earnings each climb during that period. Think of it as a race between the two. As long as future earnings are growing faster than interest rates, stock prices have the potential to keep on climbing.
Lots of factors go into determining how fast interest rates will climb, including:
- The growth rate for the general economy. The faster business spending picks up, the higher the demand for loans, and the higher interest rates will go.
- The much debated effect of higher government budget deficits. At some point the higher the deficit, the more the government competes for dollars in the debt market, thus driving up interest rates.
- The effect of currency prices. A falling dollar will put upward pressure on U.S. interest rates because, as a debtor country, the United States depends on attracting foreign capital to finance its deficits. Meantime, foreigners need higher interest rates to compensate them for the possibility that the dollars they receive will be worth less as time goes on.
- The overt policy decisions of the Federal Reserve. The Fed may decide to hike interest rates if it sees evidence that inflation is picking up, or the economy is overheating (whatever that means) or that theres a financial bubble that needs to be popped. (Dont hold your breath on that one.)
The Fed will try to stay out of the election
Greenspans Federal Reserve is never entirely predictable by design because that would let the financial markets anticipate policy moves and render them powerless.
But I think there is one part of Fed policy that investors can count on: The Federal Reserve will do its damnedest not to intrude on the 2004 presidential election. The last thing the central bank wants to do is to engineer so big a shift in the economy that the bank faces criticism that it changed the outcome of the election. To the Feds way of thinking, that means keeping the recovery on track by any means at its disposal. If that requires expanding the money supply, it will get expanded. If that means cutting rates, theyll get cut.
And it also means that it will take extraordinary evidence and then some more extraordinary evidence of runaway inflation before the Federal Reserve will move to do anything that might endanger growth in this economy in 2004. And not just any kind of growth: the Federal Reserve wants to see growth that is robust enough that it produces more jobs than the economy has produced in recent months. That, the Federal Reserves history shows, is what the Fed calls keeping out of politics.
To be blunt about it, I think the Federal Reserve will drag its feet on raising interest rates in 2004. Thats good for stocks, as projected earnings have a chance to pull ahead in their race with interest rates. And so stocks should see a good interest-rate environment in the first half of 2004.
After that, and even before the Federal Reserve actually does anything to officially change interest rates, Id expect the debt markets to move yields higher anticipating that, some time after the election, the Fed will raise rates.
And that will turn the second half of 2004 into a true horse race between earnings and interest rates.
New developments on past columns
3 solid stocks for a shaky economy
I was just about to sell my position in R.R. Donnelley & Sons (DNY, news, msgs) because the shares had hit my target price of $28 when the company announced, on Nov. 9, that it would acquire printer Moore Wallace (MWI, news, msgs) for $2.8 billion in stock. (Donnelley also will assume $90 million in debt.) The deal isnt a coup for Donnelley. It does address, however, a couple of troubling issues in the companys most recent earnings report and provides enough pluses to make me raise my March 2004 target price to $30 a share.
With the deal, Mark Angelson, Moore Wallaces CEO, will take over as CEO of the combined company. That ends a tougher-than-expected search for a CEO to take over for retiring Donnelley CEO William Davis.
Adding Moore Wallaces experience in customized bill printing should also help Donnellys struggling logistics unit. For example, while Donnelley prints phone directories for Verizon (VZ, news, msgs), Moore Wallace prints customer bills for the phone company. Donnelley says it expects to get $100 million in cost savings out of the deal in the first 12 to 24 months. And the combination should boost earnings by about 15 cents a share in 2004. On the downside, Donnelley will be acquiring some businesses with lower growth rates, and the companys commitment to maintaining the current dividend of $1.04 a share while almost doubling the shares outstanding could well lead to a credit rating downgrade. (Full disclosure: I own shares of R.R. Donnelley & Sons.)
High returns in a low interest rate world
On November 7, Berkshire Hathaway (BRK.B, news, msgs) announced that third-quarter earnings before realized investment gains climbed to $1.35 billion, a 38% increase from the $977 million recorded in the third quarter of 2002. Highlights of the quarter included the swing to profitability of the companys insurance business with after-tax underwriting profit of $258 million for the quarter instead of the $65 million loss in the third quarter of 2002. Float, a measure of the insurance premiums that Berkshire collects and has available for investment purposes, rose to $44 billion at the end of the quarter, up $2.6 billion so far in 2003. The cost of that capital was less than zero. Cash and cash equivalents at Berkshire rose to $27 billion from $10 billion at the beginning of 2003 as Berkshire sold almost all of its long-term U.S. government securities. As of Nov. 11, Im raising my target price for Berkshire Hathaway B to $3,020 by June 2004. (Full disclosure: I own shares of Berkshire Hathaway.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Berkshire Hathaway and R. R. Donnelly & Sons. He does not own short positions in any stock mentioned in this column.
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