The Dow Jones Industrials (^DJI -0.38%) had lost a modest 25 points as of 11:30 a.m. EDT. Market participants have grown increasingly nervous about just how much further the Dow can rise without suffering at least a normal correction, and as earnings multiples on some high-growth stocks have gotten extremely high, investors worry that the market might be getting overvalued. Arguing against those fears are those who think the Dow doesn't reflect the current slow-growth economic environment, with accompanying low interest rates. With Wharton finance professor Jeremy Siegel presenting this viewpoint again this morning, investors must consider whether the argument makes sense and whether the Dow Jones Industrials can soar as a result.
Source: Wikimedia Commons.
The rate argument
In simplest terms, the stock market's valuation reflects investors' assessment of the value of future streams of income that a company's business generates. The faster a company grows, the greater its future earnings will be. But another element of valuation involves how you discount those future cash flows, with the understanding that money received far in the future is worth less than money you receive today. When interest rates are low, the value of future income streams goes up, and part of Siegel's argument is that stocks should therefore get higher multiples at those times.
Proponents of the rate argument can point to some foreign stock markets to bolster their views. In Japan, the Nikkei (NIKKEIINDICES: ^NI225) has traded well above the earnings-multiple levels that you'd typically see in the U.S., with current levels in the high 20s actually marking the lower end of its range over the past 30 years. Interest rates in Japan have been extremely low for some time, with 10-year bond yields well below 1% and 30-year yields less than 2%.
Source: Flickr / 401(K) 2013
Yet interest rates by themselves don't necessarily make stocks bargains. Admittedly, many investors do make asset allocation decisions based on prevailing rates, with the recent popularity of dividend stocks reflecting the need among many income investors to generate enough cash flow from their portfolios to make ends meet. But low interest rates typically result from slowdowns in the economy, and those slowdowns typically affect corporate earnings potential adversely. Those two factors should generally offset each other in terms of share prices, leaving the Dow Jones Industrials with a higher earnings multiple but trading at a similar level.
More important, most investors remain convinced that rising long-term interest rates will come sooner than later, and that assessment is coloring their willingness to take stock market risk based on current rates. After unprecedented levels of intervention from the Federal Reserve in the credit markets, few investors want to predict how policies such as quantitative easing will end, much less invest their money based on such predictions.
As long as interest rates remain in flux, today's low rate levels aren't sufficient by themselves to justify a massive run-up in the earnings multiple for the Dow Jones Industrials. Only if rates stay low for some reason other than a broad economic downturn will corporate earnings be able to stay strong overall, and that's a necessary ingredient for the Dow to climb further from its lofty level.
