Long term interest rates are on the rise, but the stock market keeps chugging higher. Why? Are these two things in conflict? An investor determines the relative value of bonds by adding up the current value of all the coupon payments they expect to get over the life of the bond discounted by an interest rate they deem as fair. It is the same method which an investor in stocks uses to determines the relative value of the income stream they get from a business. A company's earnings vary from year to year, so the most widely used method estimates annual earnings and earnings growth expectation into the future relative to the fixed interest coupons they would get on risk free (government) bonds. Big pension funds, and the like, use these models as a guide for their appraisal of the overall market. These pricing models show that the value of a company's stock or more broadly the market should go down when long term interest rates go up and go up when long-term interest rates go down. The exception is when earnings growth changes as fast or faster than the change in interest rates. The two actions can cancel each other out, and the fair price that the model suggests doesn't change. For example, today the expected aggregate earnings of the S&P 500 companies are roughly $120-130/unit and the price is $2270 putting next year's expected earnings return between 5.3-5.7%.  If we assume that earnings and interest rates remain flat over the next year (as they have over the last 18 months) our expected return should be the average of that range 5.5%. The math of an earnings discount model is revealing! It tells you that if long term interest rates rise 1% your return expectations should also rise 1%, but that would mean a drop of the price you would be willing to pay for S&P 500 by 18% to $1920. However, if earning growth rises by 1% in conjunction with a 1% rise in interest rates the market will stand pat, and if growth accelerates faster than interest rates rise the market will go up dramatically. Last quarter the S&P 500 recorded the first genuine quarterly growth of earnings in nearly 18 months (up 3%). The market has rallied on expectations that this growth trend will continue. If it does, higher rates won't hurt the stock market, but bonds will lose value.

The Federal Reserve knows the market prices itself off a discount model. That is part of the reason why they have left interest rates low for so long. Most of the decline in the markets earnings growth has come from the energy and financial sector. The pricing model doesn't care where its earnings come from. For example, while Apple's earnings have gone up, Exxon's earnings have fallen and the total market value of the two has gone nowhere, higher interest rates under these conditions would make the sum of their market value go down. Its only when the totality of earnings are on the rise that the models indicate a higher value. That clears the way for the Fed to raise rates without causing too much disruption. The S&P 500 companies' earnings in aggregate have risen just 1.7% (.8%/year) between 2014 and 2016. Earnings are now expected to rise 10% in 2017. (Hmmm...that seems kind of fast.) History indicates you don't see acceleration like that unless rebounding from a recession. On the other hand, if the economy was just to resume its long-term trend growth one could expect 4-7%. That puts an upper bound on a fair price for the S&P 500 at about $2160 (now trading above $2270). If growth doesn't materialize one could then make the case for fair value of closer to $1900. Sentiment and growth expectations are what will determine everything in between those levels in 2017, because the Fed has clearly signaled they won't raise rates until it sees evidence of growth.

Those of you who follow the market will point out the Federal Reserve has a stated mandate of full employment and price stability, and secondarily an inflation goal or CPI (Consumer Price index) of 2%. "Price stability" can include more than just a moderate rise in consumer prices, it must also include the prices of financial assets. It's clear from the actions of the Fed that it knows that growth is the driver. People in the United States and much of the world judge the value of stocks, their homes, cars, and the day to day items they buy relative to the dollar. If they feel the dollar and US markets are stable they won't demand high rates of return on their savings, bonds, terms of trade, and the stocks they buy. Inflation will stay low while the dollar stays strong. If you want to feel good about living in the U.S. look at the U.S. dollar index, its reaching levels not seen in over 14 years. This powerful buying ability is giving U.S. consumer and business'es confidence, and that is reflected in economic activity, but it does not drive inflation. Inflation under these conditions will only come with a massive expansion in credit. This has not happened under the current administration. Fiscal austerity, regulation, demographics, and the hang over from the credit binge of the 2006-2008 period prevented this. There is an expectation that the incoming administration will be more blasé regarding credit growth, and in the near-term market earnings will be spurred by a more stimulative stance on taxes and fiscal policy. The real kicker, improving demographics, appear to lie just a few years beyond. This is a very bullish longer term story for the stock market going into the year end, but it will take time to play out. The market will get impatient, sentiment will change on a dime, and chances are good that there will be fiscal and/or monetary mistakes along the way. Like all good Christmas and New year's parties there will be a hangover. I expect that the first quarter will offer an opportunity to buy stocks at better prices. Take some gains now, and be patient. Consider dollar cost averaging into the market in the first quarter. If you are looking for relative value now the strong dollar has made international and emerging markets look cheap, but if the dollar continues to strengthen it will offset any price appreciation that may occur overseas. Investment in that segment will require patience. The U.S. bond market has been beaten down over the last quarter. Think about tucking a little there. I'd favor the side of the market that is more subject to credit risk (as the economy improves credit also improves, and that makes these types of bonds more valuable on a relative basis). You should always own some U.S. Treasuries in your portfolio, but try to weight your portfolio toward credit. Rather than just buying 100% BIV(Vanguard intermediate bond market index ETF) which is dominated by government bonds split your bond investments so that half is in the  VCIT (Vanguard intermediate corporate bond market index ETF) which will hold up better as interest rates rise in a strong and improving economy. If we do see a pull back of the market in late January take advantage and buy the VV (Vanguard large cap stock index ETF) at $92/share or better. Happy Holidays!