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Since the initiation of zero interest rate policy and quantitative easing in the aftermath of the financial crisis, the stock market has seen a dramatic increase in price with the S&P 500 bottoming at 666 in March of 2009 and recently closing at 2076 for over a 200% return. The S&P multiple has also expanded from 10x EPS to 17x EPS.
Although volatility was prevalent in 2009-2012, the rise of the Yellen Fed has essentially squashed all volatility from financial markets with the never-ending promise of zero interest rates. The modus operandi for traders and speculators has become to buy every dip in the market because the Federal Reserve continues to promise low rates and reassure investors of the sustainability of the recovery.
However, the fundamental investor now needs to ask themselves, how long can this last for? Is the promise of low interest rates enough to single handedly support the stock market?
The answer is a resounding no. The Federal Reserve does yield the most powerful tool available (interest rate policy) in the manipulation of financial markets, but not even the Federal Reserve can stop the natural ebb and flow of business cycles.
In the long-term, the single most important factor in determining the direction of the stock market is S&P 500 earnings. If earnings go up, the stock market generally goes up. If earnings go down, the stock market generally goes down. In between, investors may pay a higher multiple for that EPS or may pay a lower multiple, but the direction of EPS is all that matters at the end of the day.
- In this table, we can see that the S&P 500 earnings growth from 2002 to 2014 was 146%
- Consequently, the S&P 500 return over this period of time is 134%
- There is a near 1:1 correlation between EPS growth and S&P 500 price gains over the long-term
So the real question investors need to ask themselves is not simply what will happen to interest rates in the next year, but what will happen to the trajectory of earnings which should incorporate changes in interest rates and the economic outlook.
S&P 500 EPS Trajectory at Risk as Interest Rates Go Up
Since the depths of the financial crisis, corporate America has taken advantage of zero interest rates to juice their EPS. Corporations have borrowed money to buy back stock, have replaced high cost debt with low cost debt, have borrowed to make acquisitions, and have massively reduced operating costs.
These factors have driven the S&P 500 EPS from $60.8 in 2009 to $119.8 in 2014. However, going forward, these factors are unlikely to be the tailwind they once were. Companies have had seven years to refinance debt. Companies have had seven years to reduce their share counts and acquire other companies (while stock prices were actually low). Companies have had seven years to reduce operating costs.
In fact, if interest rates start going up, these tailwinds will flip to become headwinds. Once borrowing costs for corporations go up, the attractiveness of buybacks and M&A goes away. More worrisome is what happens to EPS when all this low cost corporate debt needs to be refinanced in a higher rate environment? Not only will we see S&P 500 EPS go down as corporate interest expense goes up, but corporations will look to use free cash flow to reduce their leverage levels, diverting this free cash flow away from productive investments that could have benefited the economy.
What happens to the S&P EPS Trajectory if the Fed Never Raises Rates?
Although everyone believes the Fed will begin to raise rates later this year, what happens if the macro data disappoints and the Fed continues to push off interest rate hikes?
Well, we won’t be in a much better position because if the Fed doesn’t raise rates it will be precisely because the economy is already slowing. However, keeping interest rates at zero for another seven years will have much less impact than it had in the past seven years simply because corporations and consumers have already had enough time to take advantage of the low rate environment by borrowing cheaply. There is a limit to how much corporations and consumers will borrow. If a consumer has $250k in student loan, auto, and mortgage debt for example, it doesn’t matter if rates are low, this consumer has already borrowed as much as he/she wants to borrow. Similarly, if a corporation is leveraged at 4.0 debt / EBITDA as a result of borrowing to buy back stock, this corporation won’t be borrowing more simply because the rate environment continues to be low.
Therefore, the stock market has already seen the benefit of low rates. So if the economy begins slowing in contradiction to the Fed’s forecasts, simply having low rates is not enough to continue boosting S&P 500 EPS. In fact, a downturn at this point in the cycle would be particularly painful for the stock market since 1) companies have less room to cut costs further to make up for slowing revenue and 2) all the Fed tools have already been used in an attempt to boost the economy and markets.
The bottom line is that the Fed has now gotten itself stuck between a rock and a hard place. If they raise rates, regardless of which month this occurs, economic growth is bound to slow as corporations de-leverage their balance sheets, consumers pull-back on large ticket purchases, and consumers and corporations alike experience higher interest costs on their existing debts. But, if the Fed doesn’t raise rates, it will be precisely because the economy is already slowing anyways in which case the continuation of zero rates will simply not be enough to single-handedly save the economy or the stock market.