What a difference a couple of months make. Eight weeks ago, oil was heading toward $20 a barrel, the market was off to its worst start in years, and calls for the death of equities were starting to dribble out of self-described market pundits.
Yesterday, the Dow Jones Industrial Average broke 18,000 for the first time since last July, oil is trading near $40 a barrel and many investors are breathing a sigh of relief, although I can never understand why more comfort occurs with higher stock prices.
There is another occurrence that took place that I believe is playing a very powerful role in springing the market back to life again: low interest rates. The market began 2016 with one of the worst starts since, coincidentally or not, the Fed began lowering interest rates amid the last recession. Interestingly, at the end of 2015, the Federal Reserve increased rates for the first time in 10 years. Rising interest rates harm not only bond prices, but stock prices as well.
After the initial rate hike in 2015, the consensus was that more hikes were in the near future. Mix that ingredient in with declining oil prices and boring corporate earnings growth and market sentiment soured. Heading into February, the S&P 500 was down nearly 11%.
Eight weeks later, the market has staged an impressive rebound -- the S&P is up nearly 3% for the year, and up 15% over the past two months. Against this rally was news that the Fed was applying the brakes to any near-term interest rate hikes.
You may think that interest rates determine stock value; they do, but not in the way you think. Low interest rates make the present value of future cash flows worth more today, so in a prolonged environment of low rates, stocks benefit from this discounting. Low interest also affect -- though not determine -- stock prices through the mechanism of opportunity cost. Low cash returns reduce the equity risk premium. In other words, lower future stock returns become more attractive if the alternative return on risk-free assets is zero.
Two months ago was a great time to buy equities if you picked your spots. IBM (IBM) could have been bought for $120 with a dividend yield in excess of 4%. Frontier Communications (FTR) could have been bought for under $4 a share with a common yield of nearly 10%; today, shares trade for $5.60. Potash (POT) could have been picked up for less than $15 with a 7% yield. Chemical and refining giant Phillips 66 (PSX) could have been bought for around $70 and now trades for $86. The list goes on.
Many, however, took a pause from stocks earlier this year and are now enthusiastic again after a 20%-plus advance in prices. The current rate environment is likely to continue stretching the potential of equity valuations. Understanding what drives stock value as well how you value stocks is critical in navigating the uncertainties of stock market investing.