Earnings, Interest Rates and Risk

When we look at the financial markets, there are really only three things that drive changes in asset prices. I will talk largely in terms of the stock market but the same rules apply to the other asset classes as well.

As the heading suggests, these three are Earnings, Interest Rates and Risk. The good news is that we can define this so simply, the bad news is that none of these are easy to nail down definitively.

Earnings

Most, but not all, financial investments are purchased in expectation of a return. For equities, this return is called earnings and one will often encounter it as Earnings Per Share which is usually compared to the Price Per Share to come up with the Price Earnings Ratio (commonly expressed as P/E). Whole books have been devoted to the subject so I will cut to the chase and point out that rising earnings are positive for asset prices while falling earnings are negative. As simple as that sounds, actually determining whether earnings are rising or falling without the assistance of a functioning crystal ball is difficult. Most of the news, opinions, data releases and sales pitches that emanate from the financial industry are trying to estimate the size and direction of earnings.

Interest Rates

Interest Rates are important because they are both the cost of money and a source of fixed income to investors. A change in interest rates can cause capital gains and losses to holders of fixed income instruments. Interest rates traditionally are massaged at the short term end by Central Banks looking to implement monetary policy while the longer end is determined by the outlook for economic growth and inflation. More recently, through Federal Reserve programs like Quantitative Easing and Operation Twist, Central Banks have tried to exercise influence across the entire “yield curve”. In general, falling interest rates are good because they lower the cost of capital for investors and generate capital gains while rising interest rates are considered bad because they raise the cost of capital and generate capital losses on fixed income holders. Like Earnings, the good news is that interest rate information is broadly available and highly visible in the present. The bad news? Markets are driven by the future expected changes in interest rates which are no easier to forecast accurately than earnings.

Risk

And finally, there is risk. Risk has a bad connotation because investors tend to focus primarily on downside risk. But risk, properly defined is a measurement of the uncertainty on both the upside and the downside. Rising risk perceptions weigh negatively on asset prices while falling risk perceptions boost asset prices. Risk can also be split into general risk factors (inflation, war, financial catastrophes) and specific factors (a particular bank’s bad loans, a company’s new product launch).

How do we determine the directions of these three?

The markets provide a dizzying array and quantity of price, data, opinions, and other information which, if properly organized, will allow us to come up with likely pathways for the three key elements. The central idea behind portfolio construction is to assemble assets that are well positioned to profit from the most likely scenarios that emerge from our analyses.