Now that you understand the basic types of investments (from Investing 101), it’s time to explain stocks and the external factors affecting them.
There are three criteria used to evaluate any individual stock (earnings, dividends, and growth) and three factors that affect the market overall (GDP, money supply, and interest rates).
Earnings, dividends, and growth
Buying a stock typically depends upon:
- Earnings per share (EPS)
- Dividends (the portion of EPS paid out)
- Prospects for growth
If you buy a stock for $50/share and the company earns $5.00/share, that’s 10% equity growth. If they keep $3.00 and pay out $2.00 in dividends, that’s even better because money is always better in your pocket. The question then becomes, can they continue to provide these returns? Or does the future hold even better figures—because they’re growing?
You look at how much the company is making, how much they’re paying out, and what their future holds. It’s always risky because nobody knows the future. Sales and earnings could fall because of competition, new regulations, loss of key management—a number of reasons. And the company could cut its dividend at any time. So holding any stock is risky even without considering external factors, but investors also look at GDP, the money supply, and interest rates because they affect every company’s potential for growth.
GDP
GDP is a general indicator of the world’s (or a specific country’s) growth. Think of it as a measure of adding all companies’ sales together. If the number goes higher, it means companies are growing.
GDP affects individual companies because we typically all grow together. So if Company A’s sales are growing, Company B’s probably are too since we’re all customers of each other. Or Company A’s employees go out and buy Company B’s products, and likewise.
If the world’s GDP (or my country’s GDP) is growing, that’s generally good for the stock market. If they’re both in doubt, than the potential for growth for most companies is compromised.
Money supply
The money supply is the amount of money out there pursuing goods (thereby causing GDP).
It includes employee wages, consumer cash, consumer assets (e.g., home values, investment portfolios), consumer debt (e.g., credit cards, home loans, car loans), corporate cash, corporate debt, government debt, family inheritances, and 75 other things.
The essence of the money supply is that when it’s increasing, it’s good for the market. When it’s decreasing, the effect is negative.
Interest rates
Interest bearing vehicles like bonds and GICs are competitive options to stocks. Their returns are lower but they come with less risk. For example, if GICs are paying 2-3%, and moderate-risk bonds are paying 4-5%, then investors should expect stock returns to be 6-7% (or greater) because of the additional risk. Make sense? I’m only going to invest in something riskier if I believe I can make a higher return.
As interest rates rise, all three of these values increase. GIC rates go higher, so bonds must pay better, and investors seek greater returns from their stocks. This pressure then drives the price of stocks down since you must now get a higher percentage yield out of the same return. For example, a $50 stock that earns $5/share, yields 10%. If interest rates rise to the point where stocks must yield 15%, the stock price will adjust downwards to $33 ($5 divided by 15%).
Predicting the future of interest rates is always tricky. Initially, they were set up to appropriately compensate lenders for risk, but then the government got involved through monetary policy (see Keynes). Regardless, the effect on stocks remains the same: as interest rates rise, stock prices go down, and as interest rates fall, stock prices go up.
Summary
In addition to evaluating individual stocks based on their own financial merit, investors also look at macroeconomic factors in determining their potential for growth.
The problem today is that all three macroeconomic factors are negative. The US’s GDP is growing but the world’s GDP is expected to fall. The money supply is expected to shrink because consumer and government debt (already at all-time highs) must now be paid back. And interest rates have nowhere to go but up.
Add to this the fact that many Canadian companies have been paying dividends in excess of earnings (essentially, eating their own flesh) to appease investors, and you have general market conditions screaming to fall. This doesn’t mean every stock will fall—but it sure makes investors nervous.