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A fixed interest guy’s take on share market volatility

What caused the share market's sharp pull-back during June 2013? Much of the analysis struggled for an explanation, but to me it seemed fairly obvious.

Typical commentaries about fluctuations in stock indices focus on earnings. When the market rises, it’s attributed to something like a positive reporting season for earnings, or some other event that means expectations for the earnings outlook are optimistic. When the market falls, there’s pessimism about earnings downgrades.

However, when the global share markets went into a tail spin from late May to late June, the standard commentary was more like:  “How can this be? The US economy is improving and earnings growth is positive. Something is wrong.” From professional equity fund managers and stock brokers to commentators in the popular press, the refrain was similar.

The trigger for the negative sentiment in world stock markets was Federal Reserve Chairman, Ben Bernanke’s comments that the time may be approaching for the Fed to start reducing its purchases of US Treasury bonds. The economy was doing better and seemed to be getting onto a more solid footing, so the need for monetary policy to provide support could be becoming less than it has been.

The majority of equity commentators focussed on the positive outlook behind Bernanke’s remarks. Surely the Fed Chairman was telling everyone to buy equities because the economy would support earnings growth!  Why didn’t everyone jump on board?

Share prices are not just about future earnings

Those commentators miss something important about share prices. While it is true that they are based on company earnings – and vitally so - they aren’t merely about earnings. They are also about the rate of return that those earnings are priced to deliver to the investor.

In technical terms, share prices are the discounted net present value of the expected future stream of earnings. Discount rates are largely determined in the bond market, and the Fed Chairman’s comments had a significant impact on bond yields and therefore on the stock market discount rate.

As a fixed interest analyst and manager, I’ve lived with this reality for decades. It’s the only thing at play in fixed interest, where earnings don’t change.  When yields go up, the value of a fixed nominal cash flow goes down.

The same principle is at work in the way markets determine share prices. It’s not as obvious because of the fact that the earnings outlook is constantly being reassessed as well, but it’s there all the time. Let me explain.

If someone offers you an investment that will pay you $100 in year one and grow by 1% a year forever, how much would you pay for it? The answer depends on the rate of return you want it to give you.

Let’s assume the asset is priced to return 5%. You’d pay $95.24 for the first year’s payment, because you’d earn $4.76, which is exactly 5% of $95.24. In year 2 you will be paid $101, for which you would pay $91.61 to represent 5% per annum over the two years. Making the same calculation – compounded of course – for each other year generates a series of amounts that add up to $2,500.

Now let’s suppose that the earnings outlook improves and the promise is a payment of $100 that will grow by 1.5% a year.  If still priced to return 5% then every payment is worth more and the total asset value would rise by 14% to $2,857.  For example, the year 2 payment of $101.50 when discounted is worth $92.06.

But what if the assumed rate of return – the discount rate - is also now higher? How does the outcome change? If, say, the discount rate goes up to 6.0%, then the year 2 payment of $101.50 is now only worth $90.33. Repeat the calculation for every year into the future and the total value of the asset comes to $2,222. This is 11% below the original $2,500 price despite the stronger earnings growth.

Equities are long duration assets

These are all large percentage changes because, in effect, equities are long duration assets. That is, the average time over which investors receive their cash flows is very long. This means that share prices are highly sensitive to changes in the assumptions about both earnings growth and the discount rate that is used to value the earnings outlook.

So, what I think happened to shares during June was this. The earnings outlook was positive, but that was already priced into the market after the strong run up in prices that had taken place in the first few months of 2013. (That rally saw the US and Australian markets up about 18%, implying about a 1% per annum average improvement in earnings growth had been priced in.) The bond market’s reaction to Bernanke’s remarks was that less buying by the Fed would mean higher bond yields. With the long bond rate as the key input to the discount rate, the equity market reacted exactly as a long duration asset should when there is a rise in its discount rate. The expected stream of earnings was now required to deliver a higher rate of return and thus the price for those earnings had to be reduced.

The duration of the stock market is in most cases a similar figure to the price-earnings ratio. That is, currently around 17 years. So, working backwards, I infer from a 10% fall in the Australian share indices that the discount rate was increased as a result of Ben Bernanke’s policy signal by just over 0.5%.  This lines up pretty well with the fact that the ten year bond rate in Australia rose from 3.2% to 3.8% over the late May to late June period.

I’m not suggesting that this was a conscious move by market participants, overtly thinking that the discount rate has gone up 0.6% so share prices have to be cut by 10% (0.6% x 17). But implicitly this is the dynamic at work as all the actions of all the buyers and sellers combine to determine the prices at which shares trade.

Therefore, the falling market in shares that followed Bernanke’s statement was not, to me, the surprising, inexplicable thing that it seemed to be to so many commentators. It was logical, with the world’s bond markets and stock markets moving in lock step with one another as investors and traders tried to understand the significance of what Bernanke was saying.

That doesn’t mean that whenever bond yields go up, share prices always go down. If yields rise because there is another improvement in the economic and earnings outlook, then the rise in earnings growth expectations may well dominate the share markets. A 1% rise in earnings growth expectations combined with a 0.5% rise in the discount rate would still produce a positive valuation impact on share prices of about +8%.

These simple maths also help explain why the share market is so volatile. It’s not that it’s an irrational, casino-like beast that bucks and dives for no good reason. No, it’s just a long duration market reacting to changes in earnings growth and discount rate assumptions.

Thinking about markets like this doesn’t produce as many startling headlines for the press. But it does help you understand why your financial planner probably keeps trying to tell you not to worry about periods as short as a month. Shares are long term assets that should be looked at only over the long term. In the same way bonds are medium term assets that should be looked at over the medium term, not weeks or months. If your time horizon is a month, then the asset that aligns with your time horizon is cash.

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management, and is now an External Member of the GESB Board Investment Committee and a consultant and writer on fixed interest, including for KangaNews.


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