Next week, the Federal Open Market Committee (FOMC) will hold a two-day meeting. As has been the case for several meetings now, many economists, traders and other Fed watchers will be looking for hints about when the first rate hike will be announced. Given that so many forecasts about the Fed have been wrong, I’ll continue to refrain from making any predictions.
What I will do instead is call your attention to the “dots.” These are the individual forecasts of FOMC members. Specifically, it's what members expect the federal funds rate will be in the future. The term refers to the dot chart used to plot the forecasts. If you want to sound like you’re in the know about the Fed, talk about the dots.
Forecasts are always fraught with the potential for error since everyone is working with cracked crystal balls. Yet, the dots have implications for stock valuations. PIMCO’s Marc Seidner pointed this out at the CFA Institute’s Financial Analysts Seminar, which I’ve been attending this week. The FOMC members’ wide-range of forecasts makes it more difficult to value stocks.
The problem applies particularly to discounted cash flow (DCF) methodologies. DCF calculates the present value of a future stream of cash flows. In simpler terms, it determines what a future stream of cash flows is worth.
DCF models consider three basic inputs: future cash flows, interest rates and a risk-compensating rate of return. Cash flows are based on forecasts of what an investor (or analyst) expects will be realized by a company into the future. The risk-adjusted rate of return is the additional compensation an investor would require to put his or her money at risk of a loss. Interest rates are what a safe rate of return is expected to be in the future; this is the benchmark rate an investor could choose instead of the risky investment.
There is one big problem that should jump right out at you: the required assumptions. DCF models require the forecasting of future cash flows and future interest rates. Since the formula typically considers several years of anticipated cash flows as well as a terminal value reflecting the value of all cash flows beyond a future period in time (e.g., beyond five years from now), even seemingly small changes in the assumptions can lead to big differences in the calculated value. Which brings us back to the FOMC’s forecasts. The spreads between the most dovish and hawkish year-end fed funds target rates are 0.1275% to 0.75% for 2015, 0.3875% to 2.875% for 2016, and 2.0% to 3.875% for 2017. In other words, even assessing an appropriate interest rate to use in the calculation is a big guess. (Not to mention the implications for a company’s future interest expense, which impacts its cash flows.)
Even if the spread between the lowest (dovish) and highest (hawkish) forecasts doesn’t seem that large to you, realize that even small differences can have a big impact on the values calculated by DCF models. Because these models consider several years of cash flows and then discount them back, altering the growth rate, the risk rate or the interest rate by even a small amount alters the outcome. Anyone who has used a DCF model can attest to this. As such, I think DCF, and similar models, are best used to check the reasonableness of other valuation assumptions.
While it’s true that uncertainty always exists in terms of forecasting future interest rates, the FOMC is in unchartered territory with no rate hike having occurred since June 29, 2006. (Yes, it has been nine years since the FOMC raised its target on the fed funds rate.) This fact contributes to the large amount of energy spent on trying to predict when the first rate hike will occur. It is also why there is so much uncertainty about what will happen to interest rates and bond yields once the FOMC finally changes to a tightening stance.
- Selecting a Valuation Method to Determine a Stock’s Worth – Discounted cash flow models work in some circumstances, but there are other alternatives as well.
- Valuing Young Growth Companies – Aswath Damodaran walks investors through the steps of valuing a young company with uncertain future cash flows.
- Do You Consider Future Growth When Valuing a Company? – Tell us on the AAII.com Discussion Boards
About 170 S&P 500 member companies will report earnings next week. This group includes Dow Jones industrial average components E.I. Du Pont De Nemours And Co. (DD), Merck & Co. (MRK) and Pfizer (PFE) on Tuesday; Procter & Gamble Co. (PG) on Thursday; and Chevron Corp. (CVX) and Exxon Mobil Corp. (XOM) on Friday.
The Federal Open Market Committee (FOMC) will hold a two-day meeting starting on Tuesday. The meeting statement will be released on Wednesday afternoon.
Elsewhere on the economic calendar, June durable goods orders will be released on Monday. Tuesday will feature the May S&P/Case-Shiller housing price index and the Conference Board’s July consumer confidence survey. June pending home sales will be released on Wednesday. Thursday will feature the first estimate of second-quarter gross domestic product (GDP). The University of Michigan’s final July consumer confidence survey, the second-quarter employment cost index and the July Chicago Purchasing Managers Index (PMI) will be released on Friday.
The Treasury Department will auction $26 billion of two-year notes on Tuesday, $35 billion of five-year notes and $15 billion of two-year floating-rate notes on Wednesday, and $29 billion of seven-year notes on Thursday.
- Should You Maintain an Allocation to Bonds When Current Rates Are Low?
- Social Security Strategies for Couples
- Why Buy Bonds If Interest Rates Will Rise?
Optimism rose to a four-week high in the latest AAII Sentiment Survey. Pessimism also rose as neutral sentiment fell to a five-week low.
Bullish sentiment, expectations that stock prices will rise over the next six months, rose 1.7 percentage points to 32.5%. This is the first time optimism has been above 30% on consecutive weeks since April 30, 2015. Even with the increase, bullish sentiment remains below its historical average of 39.0% for a 20th consecutive week.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell by 4.1 percentage points to 41.9%. This is the lowest neutral sentiment has been since June 18, 2015 (40.3%). The drop is not large enough to prevent neutral sentiment from staying above its historical average of 31.0% for a 29th consecutive week and above 40% for a record 16th consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 2.4 percentage points to 25.6%. The historical average is 30.0%.
The recent rise in large-cap stocks, including the record high set by the NASDAQ earlier this week, has helped to make some individual investors more optimistic. Since the beginning of July, bullish sentiment has rebounded by a cumulative 9.9 percentage points. The level of optimism remains low by historical standards, however, as bullish sentiment has not been above its historical average since March 5, 2015.
Keeping some AAII members optimistic is the Federal Reserve’s still-accommodative monetary policy, the ongoing bull market, sustained economic expansion and earnings growth. Causing some AAII members to be cautious are concerns about the possibility of a sizeable decline in stock prices, the pace of economic growth, the lack of wage growth, valuations, the impact of the stronger dollar on earnings and geopolitical events.
This week’s special question asked AAII members for their opinion on energy stocks. The majority of respondents were split into buy/attractive and sell/avoid camps. Nearly 37% thought energy stocks are getting attractive or are otherwise cheap. A large number of these respondents clarified their statements by saying energy stocks are attractive as long-term investments, but may not rise much over the short term. Slightly more than 39% of respondents said that energy stocks should be sold or otherwise avoided. Some cited expectations for further downside, while others pointed to excess levels of oil inventories. About 5% of respondents thought energy stocks rate as a hold right now. The possibility of Iran selling oil worldwide was also noted by some respondents as creating additional uncertainty for oil stocks.
Here is a sampling of responses:
- “I am not purchasing new shares as I believe that the energy market is in a state of flux.”
- “They will be a buy later; we need to see another dip.”
- “Beaten down badly, likely a buying opportunity.”
- “Energy stocks are down to a level that makes them a long-term buy, but in the short term, they have further to fall.”
- “I feel there are further declines coming.”
- “It’s a good buying opportunity for selected energy stocks.”
Bullish: 32.5%, up 1.7 points
Neutral: 41.9%, down 4.1 points
Bearish: 25.6%, up 2.4 points
Local Chapter Meetings
July 16, 2015 Consider Your Tolerance for Risk Before Abandoning Bonds
July 9, 2015 Historical Similarities Are Not Guides for China and Greece
July 2, 2015 My Notes From the Morningstar Investment Conference
June 25, 2015 I’m Creating a New Stock Strategy