A simple way to understand a complicated stock market

This post is from staff writer Richard Barrington.

The stock market has been taking its lumps over the past month, with the most consistent source of upset being speculation over when the Federal Reserve would end its aggressive stimulus program of low interest rates. The irony is that this speculation has been triggered by improved economic news — and that should be good for stocks, right?

It’s more complicated than that, but at heart it’s simple. It all boils down to the formula P = E/I. If you want to understand why sometimes the stock market reacts badly to good news, then you should get to know that formula.

How interest rates relate to stocks

Bill Manning, who I used to work for at Manning & Napier Advisors, Inc. is a brilliant man with one of the most complex minds I’ve ever encountered. And yet, he used to like to explain stock valuations in the simple terms of P = E/I, where P is the price of the stock, E is for earnings, and I is for interest rates.

It’s easy to understand that if earnings go up, the price of a stock should go up, but where do interest rates fit in? For one thing, interest rates are in competition with stocks — the higher interest rates are, the more tempted people will be to leave the stock market for bonds and other interest-bearing vehicles. Also, interest rates represent the effective cost of money you put in the stock market. That cost may be felt directly because you borrow money, or indirectly as the opportunity cost of not earning interest on that money.

In any case, interest rates work against stocks, but only in the context of what earnings are doing. That’s the logic behind P = E/I. Stock prices can go up if earnings rise, but also if interest rates go down. Stock prices can fall because of declining earnings, but also because of rising interest rates. If earnings and interest rates both rise or fall at roughly the same pace, it’s a wash.

So, to bring this back to the recent stock market, the prospect of rising interest rates is unsettling to stock investors — especially when interest rates are so low that they have a considerable way to rise.

The mortgage example

If you are not an avid stock investor, or even particularly fond of math, another way to understand this is if you have ever shopped for a house. You set a budget for what kind of a monthly mortgage payment you can afford. The higher the mortgage rates go, the more of that payment must go to paying interest expense, and the less can go towards the price of the house. This is a common example of how higher interest rates can suppress prices.

What now?

Back to the Federal Reserve. In anticipation that it might end its intervention, mortgage rates and especially long bond yields have headed higher. In response, the stock market has headed lower, at one point dropping by more than 5 percent from its late-May high.

What seems forgotten in all this is that the Fed would be ending its economic stimulus because the economy had succeeded in showing sustained signs of recovery. While interest rates might be rising, so should earnings. In the P = E/I equation, that should be more or less a wash, right? Unfortunately, the stock market got a little ahead of itself earlier this year.

Basically, the stock market anticipated rising earnings without accounting for the fact that interest rates would have to rise eventually as well. In other words, it wanted both the economic recovery and the continuing stimulus of low interest rates. The crashing sound you’ve been hearing lately from Wall Street is that unrealistic expectation coming back down to earth.

Still, as long as the economic recovery isn’t knocked off track by rising interest rates or by the turmoil in stocks — which admittedly, are potential stumbling blocks — some silver linings to recent conditions might start to reveal themselves.

The silver linings — eventually

Here are a couple of those silver linings:

1. The recovery might be felt more on Main Street than on Wall Street. Rising interest rates might mitigate the effect of earnings improvement on stock prices, but for unemployed people going back to work and current workers starting to see better wages, a continued recovery would be overwhelmingly positive.
2. Savings account rates might start to recover. Stock returns might suffer from higher interest rates, but once those rates start to impact bank deposits, millions of Americans who’ve seen their interest dwindle to nearly nothing will start to see a little more money showing up in their monthly statements.

As all this plays out, keep that P = E/I equation in mind. It’s a good basic way of understanding the stock market — even when the market is acting irrationally at times.