When Good News is Bad News
That economy, what a kidder!

by Ann Coleman (TMF

Alexandria, VA (February 26, 1999) -- Once again, the economy is doing so well that the market turns down. So strange.

Strange, that is, until you remember earnings, which we have been harping on for the past few weeks. Earnings are the key to these seemingly contradictory market moves. Good economic news, market goes down; bad economic news, market goes up.

It's all about the bottom line. Remember, earnings are a company's profits, usually stated in terms of earnings per share. Earnings are literally the bottom line on a company's Income Statement. It's the money that is left over after all expenses, taxes and interest is paid -- interest being the important factor here.

If you haven't really believed me when I've said that earnings are the key to stock prices, this should prove it. Stock prices have been falling this week because of fears that this great economy we are in is so hot that the Federal Reserve will try to slow it down a bit by raising interest rates.

Why do they WANT to slow it down? Good question. You would think that they would be happy the economy is growing, but an expanding economy raises the spectre of inflation, and Alan Greenspan goes into He-Man, Master of the Universe mode when that ol' Spectre of Inflation dares raise its head. And higher interest rates are the Sword of Power.

There is considerable debate, among those who enjoy debating such things, about whether inflation should be a serious concern these days. I'll leave that question to the pundits. Back in the trenches, an increase in interest rates directly impacts a company's earnings in a way that many cannot avoid. It's just like an ARM (Adjustable Rate Mortgage). If your rate goes up, that extra cash comes right out of your movie money. Companies that have adjustable credit lines are immediately affected, and companies with no current debt will get hit if they need to borrow to expand operations or get themselves through a tight spot. The higher cost of borrowing comes right out of the company's profits, thus reducing the earnings per share, thus reducing the value of those shares.

Of course, all that has been happening over the past few days is the market's reaction to the possibility of higher interest rates. Remember, even though the P/E is based on trailing earnings, what really counts is what the company will be able to earn in the future.

Besides subtracting from the bottom line, higher interest rates make it more difficult for companies to borrow, slowing expansion plans, which slows the rate of job growth, which trickles down to less consumer spending. Higher interest rates also affect consumer spending directly, of course. The net effect is that the hike in interest rates supposedly reduces not just the earnings per share, but the business's ability to make up the difference by raising prices or expanding operations.

So the market may mark time for a while until it gets some good bad news.

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

02/26/99 Close
Stock  Change   Last
CAT  -   1/8   45.56
JPM  -1  1/8   111.44
MMM  -1  3/16  74.06
IP   -   1/4   42.00
                   Day   Month    Year   History
        FOOL-4   -0.86%   2.80%   0.64%   2.14%
        DJIA     -0.64%  -0.56%   1.51%   1.11%
        S&P 500  -0.54%  -3.23%   1.06%   1.30%
        NASDAQ   -1.67%  -8.69%   4.35%   5.78%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     45.56     5.76%
 12/24/98    9 JP Morgan    105.51    111.44     5.62%
 12/24/98   14 3M            73.57     74.06     0.67%
 12/24/98   22 Int'l Paper   43.55     42.00    -3.56%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1093.50    $59.50
 12/24/98    9 JP Morgan    949.62   1002.94    $53.32
 12/24/98   14 3M          1030.00   1036.88     $6.88
 12/24/98   22 Int'l Paper  958.12    924.00   -$34.12

                             Cash     $28.26
                            TOTAL   $4085.57