A few things have happened in the past couple of days. But most people are focused on the stock market, which dropped sharply, bounced, and then pulled back again. As a result, there have been a number of headlines about how the bear market is back, and so forth. For the average investor, this kind of volatility is worrisome. How bad can it get?
That is a real concern. But the way to approach it is not to look at the market itself. The stock market values companies, but those values are a result—not a cause. In order to see where the market is and where it is going, we need to examine the underlying causes. For the stock market, there are two: corporate earnings and stock valuations.
Earnings and Valuations
If you think about it, you can see why this is. When you buy a share of stock, you are buying a piece of a company, which is to say (from a practical perspective), a piece of that company’s earnings. If you buy a stock in a company that is earning $1 per share, then you can expect, as an owner, to get the economic benefit of that $1. If earnings go up, so will your benefit, and vice versa.
But the earnings themselves—as important as they are—are not determinative of what you will pay for those earnings. You might pay $1 for that $1 of earnings, or you might pay $100 for that same $1 of earnings. The first would be a price-to-earnings ratio of 1, while the second would be a price-to-earnings ratio of 100. Put another way, the annual return on your investment would be 100 percent for the first scenario and 1 percent for the second. The price-to-earnings ratio defines what kind of return you expect from the company. The lower the return you are willing to accept, the higher valuation you can pay for that stream of earnings.
Higher Rates, Lower Valuations
How low a return you will accept for that stock and, therefore, how high a price you will pay is a key part of the pricing decision—and that depends on interest rates. To see why, consider your own investments. Suppose you have $1,000 to invest, and suppose you can get a government-issued bond that will pay you 10 percent a year virtually risk-free. Now, look at a stock that has earnings of $1 per year. How much will you pay for that stock? Remember, you can get 10 percent virtually risk-free in a government bond. So, you would want to get more than that from the stock, to pay for the extra risk. Other things being equal, that stock would be worth less than $10 per share, to give a higher return than 10 percent. By the same logic, a higher risk-free interest rate of 20 percent would mean you would only be willing to pay less than $5 per share. The higher the rate, the better off you are not buying the stock, and the less you will be willing to pay. Higher interest rates mean lower valuations for stocks.
Rates Explain Recent Volatility
This brings us back to the past several days. Stocks dropped on rising interest rates, which makes mathematical sense; then rallied on a sudden decline in interest rates; then dropped again as rates stabilized at a still high level. With no real news about earnings, rates explain the recent volatility. And that also gives us some guidance over the near future.
When we look at rates, we can see the sudden spike, to near 4 percent for the U.S. Treasury 10-year note, but we can then see a sharp pullback. There seems to be real resistance there. Looking back at history, we can see why, as it is close to the highest level since 2002. Over the past 20 years, rates have seldom gone above 4 percent, and then by a limited amount. Looking at history, we may be close to peak rates, which is consistent with recent market behavior.
That also is reasonable given the very hawkish expectations around Fed policy. With Chair Powell branding himself as the new Paul Volcker, markets expect the Fed to keep hiking. With expectations so hawkish and with long-term rates peaking and pulling back anyway, it is hard to see what will push them even higher in the short term.
Close to the Bottom
And this is comforting. If rates look likely to stabilize at current levels, so should valuations—which would mean we are close to a bottom. If earnings outperform expectations, which they historically do, that would also provide some cushion. And if inflation starts to moderate, and there are signs that it is, then expectations might become less hawkish. All of these would mean we are close to the bottom of this cycle.
That’s not guaranteed, of course, and we certainly should keep an eye on interest rates to look for more volatility. But conditions are better than the headlines would suggest, and the medium- and longer-term prospects remain favorable, despite the short-term risks.
As investors, we need to keep focused on our goals, which have not been affected by the recent pullbacks, and pay as little attention as possible to the bumps along the way. Yes, the volatility is scary—but this too will pass.
Keep calm and carry on.
Government bonds are guaranteed only as to timely payment of principal and interest, and, if held to maturity, they offer a fixed rate of return and fixed principal value. Government bonds do not eliminate market risk. Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.