Stock markets face a big challenge

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Many factors come into play when trying to value stock markets.

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Arguably the two most important factors are the future earnings of the collective stock market index and, of course, interest rates.

The first factor is fairly obvious. The higher the collective earnings of stocks within an index, the higher the valuation of the stock market as a whole. Of course, the reverse applies, as collective profits decline for companies, so does the value of the stock market.

The second most important factor affecting stock market valuations is the level of interest rates. When interest rates fall, stock values ​​generally rise and when interest rates rise, stock values ​​generally fall. It has to do with a mathematical model that is most widely used by Wall Street analysts to value stocks. Essentially, the model calculates that when rates fall, the present value of a stock market’s earnings leads to a higher valuation of stocks and vice versa.

So why is all of this important?

If we look at the situation today in the financial markets, we see an interesting development that we have not seen for several years. Corporate profits have risen steadily since the height of the pandemic and have arguably peaked in the current cycle. As of now, given the dramatic rise in inflation, the cost of doing business for most stock market companies has increased.

This means that in order to maintain future earnings growth, stock market companies must either sell more goods and/or services (which is unlikely given the current very strong increase in consumer demand as well as the constraints sourcing issues that most businesses face today). with, which is likely to cause more stock-outs than increase sales) or maintain profit margins by raising prices, thereby offsetting the higher cost of doing business.

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This earnings spike comes at a time when central banks around the world are raising interest rates to fight inflation.

The above situation potentially creates an environment in which companies, and therefore stock market valuations, find themselves between a rock and a hard place, when it comes to stock market valuations. If companies do not raise their prices, their margins will be squeezed, leading to lower profits and therefore lower valuations as well.

If companies choose to raise prices, their sales volume may drop if their product or service is deemed non-essential by consumers. This would in turn lead to lower profits overall as fewer of the highest priced items would be sold.

Conversely, for essential items and services (where consumers have no choice but to keep buying – so-called consumer staples), rising costs of business can be passed on to consumers through higher prices to maintain margins.

However, since central banks have now focused on fighting inflation, if companies raise their prices, it would also cause inflation to rise even higher than it does now.

This in turn could force central banks to raise interest rates higher than they otherwise would have, in an effort to tackle an even bigger inflation problem, due to higher price increases. high companies.

Therefore, even though earnings would be maintained if companies raised prices, equity valuations could still fall, due to the higher interest rates that central banks would no doubt deploy to combat a still further inflation problem. worse. This higher interest rate would in turn cause stock values ​​to fall in Wall Street’s stock market valuation model.

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The only potential savior in the above scenario would be for central banks to soften their stance on fighting inflation and not raise interest rates as high as expected. This would then allow overall stock market valuations to rise further.

Over the next few months, the stock market will face its biggest challenge yet, in the current cycle, as rates rise and profit margins risk shrinking. Stay tuned throughout the year.

Mike Candeloro, Senior Portfolio Manager and Wealth Advisor at RBC Dominion Securities and Head of the Mike Candeloro Wealth Management Group provided this article. RBC Dominion Securities Inc. and Royal Bank of Canada are separate corporate entities that are affiliated. FCPE member. Mike can be reached at www.michaelcandeloro.com or message him at [email protected] or on LinkedIn.

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