Wednesday, August 06, 2014

Why To Invest In Stocks

I wrote an article this past weekend that provided a link to an interview with Jason Trennert conduct by Consuelo Mack of WealthTrack. The theme of the interview and the post is the belief there currently is no alternative for investors other than stocks. My article was republished on Seeking Alpha and a reader responded with several comments and questions. I responded to his questions and the reader thought the response was worthy of an article of its own. Below are the reader's questions/comments and my response.
  1. Why is the shrinking number of listed companies important?
  2. The total market cap is at an all-time high, and the ratio of total market cap to GDP is near an all time high.
  3. Is there any rigorous study that shows that currently low interest rates have a strong correlation with 'future' stock market returns?
The shrinking number of listed companies is important from the standpoint of supply and demand. If demand for stocks remains the same and the supply of available stock declines, then prices will gravitate higher, all else being equal. In the video referenced in my earlier article, I believe Jason Trennert provides pretty good commentary behind the decline in company stock listings. Certainly some companies have gone out of business since the bust. However, Trennert notes an increasing number of companies lack the desire to go public due to the regulatory and legal cost. Some of what is occurring is companies will sell themselves to private equity firms.

From The Blog of HORAN Capital Advisors

Additionally, the current environment has witnessed a pick up in M&A activity and this was cited in a recent report by Jeremy Grantham of GMO as well. The M&A activity results in reducing stock supply. Increased M&A historically is an early, late business cycle activity. Grantham and others believe we are in the middle innings of M&A in this cycle. When public companies deploy excess cash in an acquisition, the balance sheet cash that is earning virtually zero percent interest then results in the acquisition being accretive to corporate earnings.

Regarding interest rate movement and stock prices when rates rise from a low level. JP Morgan has an interesting chart showing when rates rise from a low level, below 5%, stocks have a positive correlation to the direction of the rate move. Intuitively, this might make sense in that the Fed is simply moving rates back to a neutral level in order to have fire power in the event it is needed. When rates are increased at levels above 5%, this is generally a sign the Fed is attempting to slow down the economy. Maybe inflation is beginning to become an issue, tight capacity, higher wage growth, etc. In this situation, the rate rise, when above 5%, likely would result in slowing economic activity and as such slowing earnings growth which then leads to lower stock prices.

From The Blog of HORAN Capital Advisors
Source: JP Morgan GTM
Lastly, regarding equity values and GDP, Scott Grannis of the Calafia Beach Pundit website has a good article discussing this valuation measure. The article is a worthwhile read. In short he notes valuations by this measure are at levels similar to the early 1960s. He notes in the article the early 1960s was an environment "when inflation was low and stable and U.S. interest rates were low and stable, much as they are today." Below is the valuation chart he included in the article.

From The Blog of HORAN Capital Advisors

From a contrarian standpoint, I must say the amount of bearish commentary mentioned over the past several weeks seems to be dominating the headlines. The below chart highlights the increase in Google (GOOGL) search activity for the phrase " stock market correction." Historically, market corrections do not occur when everyone expects them. Having said this, this is a seasonally weak period for equities.
From The Blog of HORAN Capital Advisors
Source: Google Trends

Disclosure: Long GOOGL and GOOG

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