Jeremy Siegel, Wharton finance professor, likes to use the analogy of a ‘tug of war’ when it comes to the impact earnings and interest rates have on stock prices. He tells his students that the numerator (earnings) and the denominator (interest rates) are in a ‘tug of war’. The analogy is playing out in a big way as market volatility in the first half has returned. There are also other factors such as fears of inflation, trade tension with China, and speculation on the real long-term impacts of US tax reform. Let’s keep it simple though, and focus on the long term drivers for stock returns – earnings and interest rates.

In an interview on CNBC Monday, Siegel summed up the ‘tug of war’ as follows, “It’s going to be a flat to slightly upward tilting year as good earnings collide with what I think will be higher interest rates both by the Fed and in the Treasury market.” Siegel went on to predict that ‘Three-point-two-five on the 10-Year [Treasury Bonds] will give stocks a pause in 2018.”

Interest Rates

Ten year rates were hovering around 2.4% late last year and started the beginning of the year with a rapid rise. They peaked at 2.92% in late February and fallen back down to their current 2.8% level. As interest rates rise and concerns of inflation flare, the denominator value for stocks come under pressure as required return for equities increases. Interest forecasts are all over the map at this point. Jeffery Gundlach at Doubleline predicted we would be at 3% by the end of 2017 and argues that we will see 6% by the next Presidential election. Siegel’s 3.25% prediction in 2018 has been called into question.

Interest Rate Forecasting

One of the prevailing models for forecasting interest is to look at nominal GDP growth. Over the long run, 10Y rates have trended to the nominal GDP rate. However, this has not always been the case. There have been prolonged periods where the rates were above nominal GDP, such as the late seventies and early eighties with the 10Y trading above 10%. In the 60’s, rates were in the 4% range with nominal GDP in the 5% – 7% range. Currently we are trending at about 4% nominal GDP growth. Inflation has been very low. Some economists argue that we could see a sustained period where the 10Y remains below the nominal GDP given low productivity growth and an aging US population. Productivity in the US does not go up in straight line. Inventions such as the internal combustion engine, electricity, personal computers and the internet have spurred huge growth in productivity but there have been periods of very weak productivity periods as well. I am very optimistic about artificial intelligence and medical technologies adding to productivity, but predicting the pace and any downside impacts such as reduction in jobs is tricky.

Earnings Outlook

Meanwhile S&P 500 earnings are projected to grow by 20% this year. Q1 earnings numbers are just coming. So far, 70% of companies are reporting beats on earnings and analysts are nudging up their 2018 and 2019 expectations. Tax law changes and ongoing efforts to reduce regulatory impacts should have a positive impact on earnings into 2019. Beyond that, there is some concern that the earnings impacts will only create a short term effect.

Market Valuation

Markets are an amazing thing. The volatility created by different expectations of earnings growth and interest rate direction is playing out with a zig zag stock chart. Investor sentiment fell dramatically in Q1 as retail investors pull back on their equity allocation.

Overall, behavioral finance teaches us that recent information (including volatility!) is overweighed in decision making. For this reason, with high market volatility I tend to focus on the intermediate term outlook given prices, interest rates and earnings. Yes, we have volatility, but I think the right way to deal with that is to carry the correct amount of equity – bond allocation along with a bias toward lower volatility sectors that should out-perform in the later part of the business cycle (e.g. defensive stocks as well as quality stocks with high gross profitability, good cash flows and reasonable book-to-market valuation). In short, the market volatility has been somewhat helpful for PE ratios as the earning – interest rate battle has unfolded. This actually helps blow off a bit of steam and keeps PEs in check. Currently the S&P 500 is trading at 18x forward earnings and if interest rates moderate this is a fair price.

Siegel’s Outlook

Although Siegel pointed out that he doesn’t see 10-15% gains over the year as some predict, he is not recommending selling stocks. Siegel noted, “I’m not predicting a bear market. Valuations are still very attractive for long-term investors. We’re selling around 18 times this year’s earnings. I wouldn’t sell out there.”