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Causal Valuation Factors Interaction

costs to meet heightened demand for their goods and services. Middle management expands as senior managers, who took on middle-management responsibility during the recession and profit squeeze, can no longer physically meet the time demands of the required effort or choose not to do so. A second, less experienced, and less well-trained production shift is hired to meet increasing demand. The second shift incurs an expensive learning curve and takes time to reach the efficiency of the core staff. The associated added costs pinch profit margins. The rate of increase in expected earnings decreases.

The decrease in the rate of expected earnings growth accelerates as Stage II progresses. Labor and raw materials costs rise. Wages, salaries, and benefits rise as unemployment decreases. The growing demand for raw materials causes upward price pressures for those materials. Productivity falls under the strain of overtime, second shifts, expanded management teams, and other cost pressures.

Cost pressures on earnings expectations further increase toward the latter part of Stage II. Labor and raw materials costs continue to rise. Bottlenecks, imbalances, and shortages occur in labor and raw materials. Bidding wars for labor and raw materials break out. Third production shifts, still more costly to train and less efficient, are hired to meet demand for goods and services. Middle-and senior-management teams expand. Productivity and profit margins fall. The rate of increase in expected earnings growth in the numerator of the Equation (3) valuation framework grinds toward a halt.

Simultaneously the rate of increase in interest rates accelerates. At the beginning of Stage II, interest rates are rising slightly. The trough in economic activity has passed. The economy is expanding. The demand for money in the normal course of economic expansion increases. Consumer confidence and spending also increase. The Fed might “lean against the wind” and slow the rate of growth in the money supply. An accelerating rate of increase in interest rates heightens risk in the Equation (3) valuation framework denominator. However, the rate of increase in expected earnings of the numerator of the Equation (3) valuation framework remains greater. Common stock prices continue to rise. The rate of that rise is less than the rapid rise of Stage I because investors are now in combination 8a from Table 1.1. Both expected earnings and interest rates are increasing. However, expected earnings are still increasing more rapidly than interest rates.

Interest rates continue to increase at an accelerating rate as Stage