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FEATURE — The major stock market averages have been climbing recently. Given all the challenges in the world, people keep asking why the market seems so happy. Inflation and interest rates remain stubbornly high while corporate profits, measured by PE ratios, are largely flat — so why all the excitement?
The first thing to understand is that the stock market is not designed to reflect the present but to forecast the future. Investors don’t buy based on today’s price. They buy based on where they think the price will be at some point down the road. So with markets on about a three-month climb, we might assume that investors believe corporate profits will be going up sometime next year.
In my opinion, a major factor in the market optimism is interest rates. Those rates have been climbing steadily for almost two years now but it appears we have reached the top, with the next move anticipated to be downward. If this is true, how would it be expected to affect corporate profits, and thus, stock prices?
Money is merely a commodity; like all commodities, it has a price. If I asked the price of gasoline, you might say it is $4 a gallon. A gallon of milk may be $3 a gallon. These things are easy to understand. But what if I asked what the price of money is? What would the answer be?
The price of money is the interest rate you pay to obtain it. Like most commodities its price changes based on supply and demand in various markets. Just as the price of milk and gas will be different in different markets, the price of money vary. For example, a strong corporate buyer can “purchase” money for a lower interest rate than a weak individual buyer.
Of all commodities, money is truly the fuel of business. In fact, I did a quick search and found that only one of the 500 businesses in the Fortune 500 operates debt-free. Almost all businesses use some level of debt to fund future growth. It is a mathematical reality that to grow a business you have to spend money before you make it, thus borrowing is generally always necessary. If borrowing costs go up, corporate profits will go down.
Companies must then increase costs to their customers which risks hurting demand. Of all the expenses a business has, the cost of money, or debt as we call it, may have one of the biggest impacts on the bottom line.
If the price of money – the interest rate – really does come down over the coming year, it will be cheaper for businesses to fund operations and growth, thus opening the door for higher profits. It is those potential profits, driven by cheaper money, that I believe investors are counting on as they push up stock prices today.
If you are to be a wise investor, you cannot invest based on what has already happened, for then you will be too late. You must anticipate what you believe will happen in the future. I’m with those who believe interest rates have turned the corner.
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