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Interest Rates and Stock Prices
While I won't go as far as saying the "wind's at our backs," we stock market followers are breathing a little easier. After an anemic first half of the year, second quarter numbers are coming in showing healthy growth in the economy and rising stock prices.
For the second quarter, the economy produced a robust 3.4% annual growth rate, despite rising energy costs. For the month of July, the S&P 500 ® Index, a guide to the overall performance of the stock market, increased from 1191 to 1234, a 3.6% gain. Last week both the S&P 500 Index and the NASDAQ ® hit new, four-year highs.
The economy, notwithstanding the market's performance, showed a 3.8% annualized growth rate in the gross domestic product for the April-to-June quarter, reported by the Commerce Department on Friday. Back to back positive performances help paint a pleasing picture for investors.
GDP measures the value of all goods and services produced within the United States and is considered the broadest barometer of the Country's economic standing.
Consumers and businesses did not seem fazed by higher energy costs as they continued to spend and invest.
Economic growth averaged 2.8 percent over the last three years, down from the 3.1 percent that originally had been reported for the period. For all of 2004, the new figures show the economy expanded by 4.2 percent, versus the old estimate of 4.4 percent. Even with the slightly lower growth, last year's performance was still the best since 1999.
Federal Reserve Chairman Alan Greenspan in a congressional appearance last week, while positive on the economy, continued to signal more interest rate hikes are in the future as the Fed continues to move to stave off inflation.
The Fed interest rate hikes have worked to help keep inflation down; especially if we measure the outlook for inflation by the 10-year Treasury bond yields, currently in the 4.2% range.
And, when these rates are put together with the S&P 500 Index stock earnings projections for next year, bulls may be encouraged. Positive earnings reported recently from companies like Daimler Chrysler ® AG ® , Bristol-Myers Squibb ® Co., Northrop Grumman ® Corp. and Aetna ® , have all helped boost investor enthusiasm.
The role interest rates play in stock valuations cannot be overemphasized. Valuation models are built on a foundation of a risk-free rate of return, commonly using the 10-year Treasury as that part of the model. In general, stocks are worth more as interest rates fall and earnings rise.
Among the more common ways of valuing the overall stock market is the so called "Fed model," which relates the earnings yield on the S&P 500 to the yield on the 10-year Treasury bond, where the earnings yield on the S&P 500 is calculated as the predicted future earning of S&P 500 firms divided by the current value of the S&P 500 Index.
To illustrate how this works, on the last business day of July, the IBDE projected 2006 earnings of $74, and the S&P 500 closed at 1234, producing a yield of 6%. The 10-year government bond yield was 4.2%. Since the model calls for the two yields to be in equilibrium, the S&P should be priced around 1761. Our rough model indicates that stocks are still undervalued. Note that this model does not factor in event and other unusual risks associated with investing.
Keith Springer, President of Capital Financial Advisory Services is a Registered Investment Advisor and a Mortgage Broker here in Natomas, located on the river at 1383 Garden Hwy. You can contact him at 916-925-8900 or Keith@KeithSpringer.com
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