Over the last few months many of the conversations we have had with clients in review meetings have covered similar topics. I am always happy to answer your thoughtful questions. The discussion that follows is a summary of the dialogues I have been having with clients recently.
What is going on in the markets and why are the values of my funds falling?
There are several significant factors affecting the value of stocks and bonds currently, the three we will address are inflation, interest rates and growth in earnings or revenue for publicly traded companies.
Why do we have inflation and what effect does it have on the markets?
During the COVID pandemic most individuals were spending less of their income. Once restrictions and fears eased people had extra cash to spend and they chose to spend it on consumable products. With the change in spending there were fewer consumable items available (cars, electronics, TV’s, computers, tablets); this created circumstances where people were willing to pay more for these items. Additionally, because of factory shutdowns and labour modifications there were fewer actual items being produced during the pandemic which also influenced inventory shortages.
Central Banks are now trying to reduce inflation through raising interest rates to make the cost of borrowing money higher and try to curb the appetite to acquire debt. The Central Banks are trying to encourage saving with higher rates rather than promoting borrowing with lower rates.
How do higher interest rates effect the price of my stocks and bonds?
First, lets discuss how interest rates effect bonds and their pricing with an example:
Let’s assume you were buying a 5-year bond at the beginning of January 2022 paying an interest rate of 1.4%. So, on a $100,000 bond you would receive $1,400 in interest each year for the next 5 years until the bond matures and at that point you get the $100,000 back as well.
Now in June 2022 5-year bond rates are 3.3%. You would only need to invest $42,400 for five years to get the same total interest as the bond purchased in January. The bond you bought in January now has a market value of around $91,000, though it will still mature at $100,000 and pay you $1,400/year. If you were to prematurely sell the January bond you would experience a loss, but you would be able to purchase a less expensive bond and have the same return.
If you own a bond fund that owns hundreds of bonds, the same effect will occur in the value on the fund if there are significant interest rate increases.
So now I see why bonds have decreased in value, how have interest rate increases effected the value of my stocks?
Stocks are based on a couple of factors with respect to interest rates. First, stocks generally have an expected higher rate of return based on a premium to guaranteed returns such as on a 30-day treasury bill. Additionally, stocks are priced based on a valuation of the company’s value. This valuation takes into consideration the cost of borrowing for the company.
So, with respect to a premium, let’s assume stocks have a premium of 4% over a 30-day Treasury bill. So, if 30-day treasury bills were paying 0.1% at the beginning of the year, stocks would have an expected return of 4.1%. Let’s assume the stock was trading at $100 at that time.
As of June, the 30-day Treasury bills have risen to 1.35%, so stocks should now have an expected return of 5.35%. If nothing else has changed with our stock (it is still expected to grow $4.10 per year) to accommodate the expected return, the price of our stock must drop to approximately $77 ($77 x 5.35%=$4.12).
Similarly, we can value stocks based on the dividend we can earn and our cost of borrowing money. Let’s assume we can purchase a stock paying a $4.00 dividend when our cost to borrow is 1.3%. If our expectation is a 5% return after our borrowing costs, then we would pay up to $63.50 to buy that stock ($4/(5%+1.3%)).
If borrowing costs increase to 2.6% and we still expect a 5% return and are still receiving the $4 dividend then the price we will pay for that stock is now $52.63 ($4/(5%+2.6%)).
Our assumptions regarding this stock have not changed, however the increase in borrowing costs result in the stock needing to decrease in value by 17% in order to provide the investor the same return.
There are reports constantly about a recession and growth in the economy slowing. How does this impact stocks prices and my investments?
In the previous examples we assumed there were no changes in our assumptions about the stock and its earnings or growth; we assumed the growth or earnings would remain the same over the coming period. However, if the earnings or company’s growth was expected to slow or decline, then its likely the price of the stock will decrease. Let’s look at how earnings impact a stocks price.
For stocks that have positive earnings there is a multiple, referred to as the price to earnings ratio or multiple. Let’s assume a stock is priced at $30 and has earnings of $2 per share. The price to earnings ratio is 15 ($30 / $2). Also assume this multiple is consistent for this stock over long periods of time. Now if your earnings expectations for this stock decreased to $1.50 per share and we maintain a multiple of 15, then the expected share price is now $22.50 ($15 x 1.5). So, with lower expected earnings the price of the stock will more than likely decrease in value assuming the price to earnings multiple remains consistent now and in the future.
Are there other factors that effect my stock or bond prices?
Yes, there are other factors that can affect share prices. However, this year we believe that inflation and interest rates have had the most significant impact.
What is next?
The logical conclusions about our observations are the following:
- The economy cannot be consistently forecasted
- The equity market cannot be consistently timed
- The only way to capture long term returns of the market is to ride out what can be significant temporary declines.
The markets move in cycles and as the markets absorb information about the future changes the market will apply all this into new prices. A short-term fix is not the solution to a long-term plan. As Peter lynch stated “The real key to making money in stocks is not to get scared out of them”
Hopefully this helps answer questions and explains our market observations since the beginning of the year and why stock and bond values have been so impacted by inflation and interest rates. As always, we are available to discuss your personal accounts and any further questions you may have.
Please reach out to Alida or Keenan if you would like to set up a call or review.