Does macro matter for stock picking?

Non-farm payroll employment figures hotter than expected.

Markets down.

The quarterly Consumer Price Index fell more than expected.

Markets up.

US Federal Reserve Chair hinted at more rate rises to combat inflation.

Markets down.

We see iterations of this daily. The financial press eagerly reports macroeconomic news on interest rates, inflation, or jobs figures…and investors lap it up.

But how much of this matters?

If you’re a stock picker, how much attention should you pay to macroeconomic issues?

It’s not the business, it’s the M-1

A corner café shuts down. Who shoulders the blame, the proprietor and their business plan or Philip Lowe?

It seems nonsensical to apportion blame in this case to a central banker.

Whatever the reasons for the café’s failure, they had more to do with the internals of the business than the economy at large.

Countless cafes fail every year, boom times or otherwise.

Alternatively, if another café is bustling, will the owners send weekly thank you cards to Philip Lowe? Or will they pat themselves on the back instead?

One of my all-time favourite investment books is Dead Companies Walking by Scott Fearon, with his tales of shorting bad businesses.

In the book Fearon recounts how in the first year of starting his hedge fund in 1991 he visited Consilium, a tech company building software to control automated factory operations.

Consilium piqued Fearon’s interest because its debt levels were rising but revenue was stalling.

A bad combination.

Yet Consilium’s CEO had a ready answer for his company’s troubles. Here’s Fearon retelling the encounter:

‘“It’s very simple, Scott,” he said. “It’s all about M-1.”

‘“M-1?” I asked. “What do you mean, M-1?”

‘“M-1,” Mark repeated. “The aggregated monetary supply. The Federal Reserve has been constraining it over the last two quarters so factories aren’t spending like they used to. That’s why sales have been flat.”

‘“Hold on,” I said. “M-1 is literally trillions of dollars. You guys do like ten million a quarter in sales. You don’t think your problems might have something to do with the quality of your products or what your competitors are doing?”

‘“Oh no, absolutely not, Scott,” he said. “We’re rock solid. It’s the Fed. I’m telling you. They’re killing our business.”

‘I shook his hand, drove back to my office, and immediately shorted Consilium’s stock. It was trading at $17 at the time. Over the next year, the company’s revenue growth continued to disappoint and its share price turned south. I covered my position at just under $10, but the stock continued to trend down after I got out. In 1998, technology giant Applied Materials acquired Consilium for about $7 a share.’

Consilium’s CEO was looking to cast blame on everything other than the business itself. But the root cause of Consilium’s problems was intrinsic, not extrinsic.

Fearon then concluded with a great passage (emphasis added):

‘Another excuse I see is our country’s “sluggish economy.” That precise phrase is frequently employed in press releases and corporate disclosures. Having lived through a number of genuine economic collapses in my career — the 1980s Texas oil bust, the bursting of the dotcom bubble, and the 2008 financial crisis— I usually find this explanation for disappointing results less than convincing.

‘The US churns out more than $17 trillion in economic output every year. We have the most dynamic and sophisticated economy in the history of the world. Blaming an individual company’s lackluster performance on slight variations in that ocean-sized system is like saying a typhoon in Japan caused flooding in Mazatlán. Sure, it’s remotely possible, but there are a whole lot of other factors at play, and what’s happening inside a company almost always trumps what’s going on outside of it.’

What’s happening inside a business almost always trumps what’s going on outside of it ... like inflation, interest rates, jobless figures, or the money supply.

Stocks aren’t just businesses

But stocks aren’t just businesses.

They’re businesses operating in public markets where price matters as much as performance.

And what investors are willing to pay for a public business depends on their opportunity cost — their required rate of return or discount rate.

If a mundane (and safe) term deposit offers you 10% a year, many stocks become unappealing.

When cash can yield you attractive returns, stocks can only compete when their relative value falls.

All of a sudden, macro matters again. 

And macroeconomists the world over nod their approval. Here’s Columbia’s Frederic Mishkin:

‘An important determinant of stock prices is monetary policy … the impact of monetary policy on stock prices is one of the key ways in which monetary policy affects the economy.’

A quick illustration can suffice.

When a central bank cut interests rates, the return on safe assets like bonds falls. Falling yields on safe assets lower investors' required rate of return. 

And a lower required rate of return — or discount rate — is a major variable in traditional stock valuation models that calculate the present value of future cash flows.

For simplicity’s sake, let’s use the dividend discount model I’ve talked about before. Here’s the formula:

Stock price = DPS/(r-g)

Where DPS is expected dividends per share a year from now; r is the discount rate; and g is the expected long-term dividends growth rate.

Say stock ABC is expected to pay $1 in dividends per share next year and will continue to grow dividends at 3% a year indefinitely.

When rising interest rates push the discount rate to 10%, the stock is worth ~$14 a share.

When cratering interest rates drag the discount rate to 5%, the stock is worth $50.

The same stock is valued differently for reasons extrinsic to its business.

Not so fast...

Here, though, we may say that the discount rate is as sensitive to macroeconomic variables as personal questions of risk appetite and financial needs.

Just because interest rates are falling, along with the risk-free rate, doesn’t mean you should lower the discount rate you apply to a stock.

As Stephen Penman wrote in Accounting for Value (emphasis added):

‘Your disposition to risk and my disposition to risk, and our required return, are personal matters. Rather than maintaining a pretense of objectivity by measuring risk premiums that are, after all, in the mind of the beholder, we will treat the problem for what it is, one that requires your (subjective) input as to your tolerance for risk. You will need some appreciation of the risk involved in a particular investment — so you require some accounting for risk — but only you can decide the risk you will accept. Only you can price risk. You will take personal responsibility for taking on risk, rather than delegating the task to a machine model that pretends to deliver your required return.’

It's also not exactly true that a discount rate is influenced only by factors extrinsic to the business. 

A stock with a murky outlook will command a higher discount rate than a predictable stalwart, no matter the prevailing risk-free rate. 

Demand and monetary policy

Of course, another way macro matters for stocks is via aggregate demand.

After all, that’s what central banks aim to tinker with by wielding interest rates. And it would be foolish to assume aggregate demand does not affect the stock market.

Here’s Mishkin again:

‘Quite simply, when monetary policy is expansionary, the public finds that it has more money than it wants and so gets rid of it through spending. One place the public spends is in the stock market, increasing the demand for stocks and consequently raising their prices.’

Conversely, when monetary policy is restrictive, the public finds it has less money to throw around … and spending in the stock market falls, along with stock prices.

Yet, when we say monetary policy affects stock prices, we must ask which stocks are being affected.

If you’re exclusively a passive investor, macro matters a great deal. But if you are an individual stock picker, you deal in specifics, not generalities.

Macroeconomic variables may affect the stock market as a whole but not every stock moves in tandem with the average.

As my colleague Greg Canavan likes to say, it’s not a stock market, but a market of stocks.

Stock pickers should focus on that fact more than any macro variable.