Sunday, August 26, 2007

Effects of Falling Rates and Inflation on the Stock Market

In a previous article, we examined the historical Price to Earning Ratios of the US large cap index, the S&P 500.

Now, let us examine how a falling interest rate environment or low inflation situation affect stocks, stock performance, and sector performance.

Effect of Inflation on Stock Performance

Crestmont Research provides very interesting information on Inflation and Price to Earnings Ratios from 1900 to 2006.

When we look at Inflation (as measured by CPI) ranges, we see the average PE:

  1. CPI Range (less than 0%): Average PE = 14
  2. CPI Range (0 to 0.99%): Average PE = 16
  3. CPI Range (1 to 1.99%): Average PE = 17
  4. CPI Range (2 to 2.99%): Average PE = 22
  5. CPI Range (3 to 3.99%): Average PE = 19
  6. CPI Range (4 to 4.99%): Average PE = 16
  7. CPI Range (5 to 5.99%): Average PE = 15
  8. CPI Range (6 to 9.99%): Average PE = 13
  9. CPI Range (10% or more): Average PE = 8

During times of low inflation, especially in the range of 2 to 2.99%, the US equity market supports a high PE ratio of 22. As we have deflation, or very high inflation, the average PE ratios are much less. The historic average PE ratio of the S&P 500 is 14 or 16 depending on how you calculate it.

In addition, the link above shows the general inverse relationship between inflation and stock prices. As inflation rises, stocks tend to fall. And as inflation drops from high levels (so long as there is no deflation), stocks tend to rise.

As of July 2007, the Inflation rate (through CPI) is 2.36%. Based on the chart above, this is a good inflation rate for Price to Earnings multiple expansion. As long as inflation remains contained, the outlook for US equities remains bright.

Effect of Falling Interest Rates on Stock Prices

The Fed, according to Fed Funds Futures, is likely to start cutting the Fed Funds Rate, currently at 5.25%.

How does a Falling interest rate environment affect stocks?

The Business Week magazine has an article showing the effect of falling rates and rising stock prices.

Since World War 2, the Fed has started rate cutting programs 10 times, and in the six month period after the first cut, the S&P 500 advanced by an average of 11%, two percentage points better than the average of 9% price increase in all years since 1945.

In the 12 months after the first rate cut, the S&P 500 gained an average of 18.6% and posted an increase in 9 out of 10 cases.

So for the most part, except for a few cases (such as the big drop in 2000-2002 due to excessive valuations of Nasdaq and S&P 500 stocks), falling interest rates are good for stocks.

Effect on Different Indices in a Falling Interest Rate Environment

Since 1945, during a falling interest rate environment, Growth and Blend methodologies in the S&P 500 returned 11%. Value stocks in the S&P 500 returned 7.9%. During a falling interest rate environment, large capitalization US growth stocks outperformed large capitalization US value stocks.

The small capitalization stocks as represented by the Russell 2000 or the S&P SmallCap 600 returned 7.8% six months after first interest rate decrease. However, this still underperforms the US Growth S&P 500 Index during a falling interest rate environment.

During a Falling Interest Rate Environment, it would be a good idea to invest in large cap growth stocks.

Effect on Sectors in a Falling Interest Rate Environment

Which sectors outperform and underperform during a falling interest rate environment?

According to Standard and Poors and the Business Week Article, these sectors performed in the six months after the first rate reduction (since 1945). The average percent change is listed:

  1. Information Technology: +21%
  2. Consumer Discretionary: +18%
  3. Industrials: +17%
  4. Consumer Staples: +14%
  5. Energy: +12%
  6. Health Care: +11%
  7. Materials: +11%
  8. Financials: +10%
  9. Utilities: +7%
  10. Telecom Services: +4%

During a Falling Interest Rate Environment, it would be a good idea to overweight Information Technology (Growth), Consumer Discretionary, and Industrials and underweight utilities and telecom services.

How I reallocated a portfolio to take advantage of the Falling Interest Rate Environment

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