Here’s Why You Should Worry About What Happened In The Market Yesterday

April 25, 2018

Here’s Why You Should Worry About What Happened In The Market Yesterday

The thing with the stock market is that it gives you signals way ahead of time, but nobody wants to listen. The things I’ve been blabbering about over the past two years are the following:

  1. Higher interest rates will come just as the FED told us they would.
  2. Higher interest rates will squeeze valuations.
  3. Higher interest rates will slow down economic growth.
  4. Higher interest rates will slow down earnings growth.

So, let’s start by discussing these.



The 10-Year Treasury Passes 3%

When the 10-year Treasury was below 3%, nobody seemed to care except a few crazy analysts like this scribe. However, when it crossed 3%, the market suddenly looked at what had been going on for nearly the last two years.

Figure 1: 10-year Treasury yield in the past 2 years. Source: FRED.

And suddenly it become a good media headline, the markets finally react to rising interest rates, and on Tuesday, stocks had another bad day.

Figure 2: S&P 500 up to Tuesday, April 24. Source: CNN Money.

Now, sooner or later, higher interest rates must impact valuations because if you invest in the 10-year Treasury, you have a guaranteed 3% yearly coupon now and a guaranteed principal payment in 10 years. This means that dividend paying stocks must trade at a premium on that. And what is important to grasp is that when the required dividend yield goes form 3% to 5%, the stock price falls 40%. Let me explain this in depth:

So, if you’ve been wondering what has been going on with dividend cash cows like Altria (NYSE: MO), apart from the normal regulatory noise and declining sector trends, it is higher required yields.

Figure 3: MO lost 22% in the last 3 months. Source: CNN Money.

Further, there are other negative forces influencing stocks. Higher interest rates make everything more expensive, especially in a global economy that is fueled by debt. And this means less demand for lots of things. For example, the 30-year fixed interest mortgage rate in the U.S. is flirting with 4.5%. Mortgage rates 1% higher mean higher costs and increased gravity on home prices and real estate activity.

Figure 4: U.S. 30-year fixed mortgage interest rates. Source: Zillow.



Now, higher interest rates also impact businesses because what was profitable with a cost of capital at 3% suddenly isn’t profitable if your cost of capital is now 5%. Consequently, companies like Caterpillar (NYSE: CAT) and 3M (NYSE: MMM) have lowered their 2018 guidance.

And you might wonder why it’s so important when 3M just lowered its top range profit guidance range for 2018 where earnings were expected to be between $10.20 and $10.70 while now they are expected to be between $10.20 and $10.55. The key is the trend. JPMorgan issued a statement that there might be more downside as raw material prices have been going up.

Also, Caterpillar told us that it doesn’t expect higher margins than it obtained in Q1 2018 as input costs rise. However, what’s important to note is that all these estimates are made by using current economic data and not discussing what could happen. Let me show you how revenue and earnings estimates usually drift downward as we get closer to the actual earnings date.

Figure 5: Revenue estimates always drift downward. Source: Wall Street Journal.

So, analysts are usually about 10% to 20% wrong on estimated revenues and about 35% wrong when there is a recession. Consequently, the situation with earnings is even worse.

Figure 6: Earnings estimate revisions for the FTSE 100. Source: Macro Matters.

So, average earnings estimate revisions on FTSE earnings have been around 40% in the last 10 years over a period of a year. There’s a similar case with the S&P 500, but what many forget that, in case of tighter financing conditions and just a small recession, earnings might even contract 50% from what is expected.



Conclusion

This is what is going on with the markets. The potential catalysts that can push the markets higher are severely outweighed by the risks that can pull it downward from interest rates, growth slowdowns, and contracting earnings. This might not be a bad thing per se but given that valuations are historically extremely high, small changes have a big impact on stocks.

Who will get hurt the most? The stable dividend yielders that have high payout ratios, high debt burdens, and have been giving an air of stability over the last 10 years of extremely low interest rates. REITs come to mind and companies like Procter and Gamble (NYSE: PG).

PG’s earnings didn’t go anywhere in the last 10 years (2008 – $3.64, 2017 – $3.77), but the payout ratio increased from 50% to 77%. The book value is even lower than it was in 2008 ($22.45 vs. $21.21), but the stock price increased from to high of $94 just a few months ago. The current price of $72 means that dividend investors will need to collect a lot in dividends to cover for the loss.

Figure 7: PG’s stock price over the last 5 years. Source: CNN Money.

The point is that you should never have a fixed mindset when investing in stocks.



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