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Kudlow: S&P 1560?
By Lawrence Kudlow
Contributing Editor
Mar 7, 2001 03:56 PM
So far it hasn't been much of a new millenium for stocks, which have been hit hard by shrinking profits, a slumping economy, tight money, energy shocks, rising tax burdens and dot.com deflation. Market pessimism and cynicism are out in full force. Bulls have mostly stayed behind closed doors.
But there's an obvious bright spot in the outlook that is too often overlooked: declining interest rates. Across the maturity spectrum, Treasuries, investment-grade corporates, high yield corporates, and tax-exempts have been declining in yield.
For the economy and the stock markets, this means that help is on the way. In particular, the decline of short-term interest rates, which began in November for Treasury bills, and January for commercial paper and the bank prime rate, bodes well for recovery.
Especially the signal from three-month Treasury bills, a frequently ignored rate that captures short-term variations in the economy, inflation expectations and inflation-driven tax burdens (such as the unindexed capital gains tax).
Also, of course, the T-bill rate captures expected and actual Federal Reserve policy moves. Last November the declining bill rate correctly anticipated the January Fed U-turn toward less restrictive money. Now the drop in T-bill rates is signaling a declining inflation tax on the economy and an increase in financial liquidity. These are good things.
The Treasury bill rate also has significant forecasting properties. In models developed years ago by economists Arthur Laffer and Victor Canto, and various offshoot models used by many others (including myself), the T-bill rate sends two messages.
First, as a coincident indicator, the bill rate tracks the current economy. For example, the steep bill decline, from 6.44% last November to 4.70 percent recently, marks the unexpected collapse of economic growth from a robust 5.3 percent in last year's first half to a discouraging 1.7 percent in the second half.
Second, as a forecasting indicator, with variable lags of six to twelve months (or sometimes longer), the bill rate predicts future economic growth and profits. Assuming the T-bill rate falls to 4.25 percent this year, our version of the model suggests 1.1 percent annualized real GDP growth for first-half 2001 and 2.8 percent in the second half.
In terms of profits, the T-bill model predicts that the four-quarter change in after-tax S&P 500 operating earnings comes in at a negative 2.6 percent in Q1, then 0.9 percent in Q2, 4.7 percent in Q3 and 6.6 percent in Q4.
As for the stock market, the T-bill rate can be used as a discount factor to capitalize expected future earnings. Dividing expected profits by the T-bill rate provides capitalized profits, a proxy for future stock market value. With falling T-bill rates and a modest profit improvement, the model projects capitalized earnings to rise 40 percent by yearend 2001. This is a significant buy signal for the S&P stock market, which could rise by roughly 25 percent from current levels.
For skeptics, it is noteworthy that the T-bill model of capitalized earnings put out a sell signal eighteen months ago. From mid-1999 through the end of 2000, capitalized earnings declined by 17 percent (as T-bill rates rose significantly, while profits slowed). The drop in capitalized earnings foreshadowed the subsequent market slump.
Importantly, the T-bill model of capitalized profits and the stock market captures a basic investing truth. When the Fed is tightening, get out of the way. However, when the Fed is easing, get back into the game. Rising short rates often trump strong earnings. Falling short rates often override week earnings. Capitalized profits tell the story.
Right now the Fed is easing, a big plus for investors. Additionally, declining energy prices become increasingly less of a drag on corporate profits and consumer purchasing power. Also, the Y2K hangover (huge over-investment in 1999, borrowed from 2000 and 2001) may soon be coming to an end. And while technology stocks are way down, the economic benefits of the long-cycle technology innovation and spillover wave are alive and well.
Meanwhile, while the Fed may belatedly lower the funds rate another 100 basis points, the House Ways and Means tax bill will delay the supply-side effects of lower marginal tax-rates until 2002 and beyond. This will dilute the potential economic boost to investment and capital formation, which may not fully kick in for many years.
This is one reason for the projection of a sub-par economic recovery, more of a U-shape than a V. Waiting for the full benefits of lower tax-rates (and interest rates), entrepreneurs, investors and, yes, rich people, will delay their risk-taking transactions. Perhaps Congress will see a better light this spring and accelerate the whole rate-reduction package. At least future tax-rates are headed down, not up.
But the key point is that declining T-bill rates imply rising capitalized profits. Capitalized earnings are a good guidepost for the S&P 500 stock market index, which could rise to 1,560 by yearend. While that's only slightly above the 1,527 peak registered a year ago, it would be a good leg up on the next bull phase. Keep the faith, investors. Better times are coming. |
