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Fear of Inflation, Interest Rate, Earning Yield

by Henry Lu
June, 2006

Huge Sell Off, Fear of Rising Interest Rate

The recent sell off was sharp and ugly. The sell off was across the board, and BIRTP* model portfolio suffered sharp losses. Should you be worried?

Here we first talk about the reason and historical background of sell off, and then we lay out our stock picking strategy in the sharp sell off..

Why the Sharp Sell Off?

The sell off started out a month ago when the stock market was full of rosy talk and bullish sentiment. The stock market in general assumed that inflation of US economy was in check along with decent growth of US economy, and that Federal Reserve (Fed) was expected to end the interest rate raise soon.

All of sudden, the rosy perception changed. Fed Chairman Ben Bernanke hinted recently that he was still worried about the ever increasing inflation risk. The Fed is likely to continue to raise interest rate in the months ahead.

Chairman Bernanke has a point.  All the relavent indicators have been showing rising inflation. Prices of medical care and education are rocketing at double digit rate per year. Average families are seeing higher price in grocery stores, at gas pump, or at monthly utility bill payment time. Commodity prices are rocketing so that average companies are seeing their raw material cost rising fast. High inflation is bad for economy, therefore, one of main jobs of the Fed is to raise interest rate to fight inflation. The higher the inflation, the higher the interest rate. The higher the interest rate, the less pressure for inflation to rise further more.

The problem is, fast rising interest rate is recipe for bad stock market. Investors panicked, then the huge sell off across the board without differentiation.

So why the rising interest rate is bad for stock market?

Cash Yield - the Ultimate Benchmark for Stock Market

Cash is important benchmark in our stock picking strategy. Cash interest return is safe return. Any investor can deposit cash at banks to earn interest, or buy government treasury bonds to obtain safe return. Stock market is competing against banks and governments for investors' money. Therefore, comparing attractiveness between cash and stocks is very valid analysis.

As value investors we believe investment return on stocks mainly comes from earning of a company,  therefore we evaluate earning yield (inverse of PE ratio)as if it is bond yield, and we can compare stock earning yield to cash yield directly. In fact, if a company pays out 100% of its earning as dividend to its shareholders, buying the stock is exactly like buying a bond and company's earning yield would become just like a bond yield.

Hypothetical Case 1
Table 1 -  Stock ABC verses Cash, as if 100% of earning is paid out as dividend to shareholders.
Ticker
Cash in Bank Account
Stock ABC
PE
20
17
Yield
5%
5.9%
Annual Earning Growth

3%
Risk
no
yes

Let's first look at hypothetical case 1 in table 1. Is stock ABC an attractive investment? The answer is "maybe". The stock ABC is paying 5.9% yield, the earning is growing at 3%. The yield of stock ABC is certainly better than cash. Cash is no-risk investment, stock is risky, so higher rate on stocks is expected. (as we explain below, our answer here is actually "no", but let's leave it "maybe" for now).


Hypothetical Case 2
Table 2 -  Stock ABC verses Cash, as if 100% of earning is paid out as dividend to shareholders.
Ticker
Cash in Bank Account
Stock ABC
PE
11
17
Yield
9%
5.9%
Annual Earning Growth

3%
Risk
no
yes


Hypothetical case 2, same stock ABC, but different cash yield at 9%. Is stock ABC an attractive investment?  The answer is definitely NO.
If an investor can get safe return from bank at 9% yield, why would he/she wants to invest into a risky stock ABC for getting lower yield at 5.9% yield? Even considering the stock earning yield is growing at 3% per year, 5.9% current earning yield is still too low.

As we can see above, the same stock ABC, the same PE, the same earning yield, could change its attractiveness depending on the current and expected future cash yield.

Margin of Safety - Significantly Higher Yield than Cash

When interest rate is rising, stock becomes less attractive. Historically, if in average stock market yields at 4% above cash, it is considered fairly priced and reasonably attractive.  In other word, in hypothetical case 1, stock ABC fair value  is around 9% - 10% earning yield or PE= 10 to 11.  Therefore, in our opinion, stock ABC is not terribly expensive,  but certainly is not very attractive at PE of 17.

What I didn't tell you in hypothetical case 1 is, the current cash yield is indeed around 5%, but the actual stock ABC is our S&P500 index.

Now with higher inflation talk and rising interest rate, it is not surprising to see the recent huge sell off. The current margin of safety for S&P500 index is not very thick.

The main difference between deep value approach verses other "relative value approach" is the comparison to cash. Many analysts only compare their stock picks to their peers in same sector, or just S&P500 index. We not only compare picks against their peers, or S&P500, we also compare our picks against cash.

No Bull on Stock Market, Not Bear on Economy

Having said above slightly bearish valuation assessment on stock market in general, we believe the current market is great time for value investors.  Historically, value stocks performed pretty well especially in bear market environment, as evidenced on the stock market since 2000, and in 1970's.

We are not bear on US economy. US economy is still growing at positive rate. Jobs are still abundant. Americans are still earning good salary with good disposable income. This is not end of the world. Our opinion has been consistent, the problem is the valuation of US stock market, not the US economy.

The inflation risk is real, the rising interest rate is real, but the same interest rate/inflation risk was there 3 months ago, or 1 year ago. This is not new problem.

Value Investing - Long Term Game

In the short term, there is no direct consistent correlation between valuation and stock price performance. Stock market does behave irrationally from time to time. Many of ups or downs are random without any fundamental change. The market can penalize cheap stocks and expensive stocks without any difference in short term. That is why a dirt cheap stock can continue to drop further and a bubble stock can double or triple.

Value investing only works in the long run. That is why it is long term oriented. 
Value investing is not a short term game.

Take CHK pick as example, BIRTP* picked CHK 2.5 years ago around $13, within months, this pick lost 20% to around $11, big pain. But look at current price, $29. The reason for all that change was fundamental business growth. CHK PE was round 10 2 years ago and now the PE is still less than 10. Over last 2 years, the earning per share doubled, so did the stock price.  We never sold a share of CHK for more than 2 years.

This is the strategy we are executing on. We don't know the stock price in next month or in several years exactly ahead. But we are banking on cheap price of less than PE of 10, and 20% or more earning growth from high earning yield. As the business of CHK grows at current rate, the earning per share will double in several years. Go figure,even if CHK will trade at same cheap PE of less than 10, the stock price would double in several years.

We don't know how BIRTP picks would do exactly in future sell off or bear market either. But we do know historically, bear market bottomed when average market PE was around 10. Many of our picks trade below PE of 10, or below the average valuation in bear market. 1970's was bear market decade, but 1970's was those years when value investing performed superbly.

In the short term, cheap valuation does not mean fast buck, or quick rise of stock price. But in the long run, value investing strategy does work.


Note:
BIRTP - Blast Investor Real-time Plus newsletter, a premium service offered by BlastInvest LLC.






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* Article by Henry Lu of BlastInvest LLC, a premium investment newsletter publisher in Connecticut.  Visit http://www.BlastInvest.com for FREE "how-to" investing assistance, web services and more.