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Oilweek Magazine: June 2010

Tuesday, June 1, 2010

Riding the wave
If interest rates ride a rising tide, will stocks follow along?

by Kevin Dehod

Corporate earnings, interest rates, and valuation are the three major drivers that determine future returns in stocks. With three-month T-bills yielding 0.15 per cent and 10-year Government of Canada bonds yielding 3.35 per cent, there has been a high degree of speculation recently about when interest rates will go up, by how much, and what the impact on stock prices will be.

Trying to predict the exact point interest rates and bond yields will rise is a low-probability outcome given the multitude of variables that are at play. However, given the current level of interest rates, it is highly likely the bias will be up over the next 12 months and this will have direct implications for stock market performance, price-to-earnings (P/E) valuations, and sector performance.

In general, when we review the tightening cycles since 1976 some clear trends emerge. By tightening cycle, we simply mean the first U.S. Federal Reserve interest rate hike after a period of declining interest rates. In Table 1, we list the performance of the S&P 500 Index 12 months prior, and one month and three months after the first fed rate hike.


Source: Morgan Stanley Research

The numbers indicate that the first phase of the stock market recovery can be very powerful and is driven by excess liquidity and falling or low interest rates. The second phase of the stock market recovery involves some consolidation or correction as the equity rally  matures. In this phase, stock markets begin to price in higher interest rates in the future, P/E multiples generally stop expanding and corporate earnings growth takes over as the key driver to sustain higher stock prices in the future. What is always unnerving and uncertain is the amount and duration of the correction as stock prices prepare to transition from a liquidity-driven market to an earnings-driven market.

The P/E ratio of a specific stock or market has a very direct and inverse relationship with the level and direction of 10-year bond yields.

In nine different tightening cycles since 1971, when 10-year bond yields have risen, the P/E ratio has only expanded once, and in all other cases has remained flat or declined. The average P/E decline over the previous nine cycles has been 15 per cent. Regardless of the Federal Reserve cycle, the median P/E multiple has fallen 8.3 per cent for every 1 per cent rise in 10-year bond yields. In this cycle, corporate earnings have been a major factor supporting the rally in stock prices and the growth in corporate
earnings has allowed stock prices in general to remain fairly valued even after the rapid price appreciation in stocks over the last 10 months. The current 2010 P/E for the S&P 500 and TS X Composite Index is 14.0x and 14.55x, respectively. Long-term averages for both markets are around 15.0x. Equities can still go up in the face of rising 10-year bond yields and flat to declining P/E multiples as long as corporate earnings continue to grow. When bond yields begin to rise, positive analyst earnings revisions and low P/E ratios become two of the most important quantitative factors that drive out-performance in stock prices.


Source: Data Stream, Morgan Stanley Research

Lastly, what sectors historically do well in a Federal Reserve tightening/rising bond yield environment? As you can see from Table 2, cyclical sectors tend to outperform defensive sectors such as banks, utilities, and consumer staples.

There are some factors that drive this historical sector outcome. It is likely that interest rates are rising due to the economic recovery that is taking hold and building inflation pressures within the economy. Robust and sustainable profit growth as a result of the economic recovery often leads to out-performance by cyclical sectors. We would caution that this analysis is purely based on historical sector trends during Federal Reserve tightening cycles.

We would place a much larger weight on today’s realities for those sectors such as current valuation, future earnings prospects, and most importantly, other fundamental factors that might exist today that didn’t in the past. An interesting observation is that currently at McLean &  Partners, we are underweight in banks in our portfolios, and within the financial sector we are biased to insurance ompanies that tend to perform better than banks in a rising interest rate environment. We are also currently overweight in technology and energy in our client equity portfolios.

So in summary, as interest rates rise, stocks go through a consolidation phase as P/E multiples flatten and/or decline. During the next phase, stocks tend to rise more in line with corporate earnings growth as the market transitions from liquidity-driven to earnings-driven. We believe during this second phase that stock picking with a focus on those companies that are cheap relative to the market and that have the ability to produce positive earnings revisions will be the ones that outperform.


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