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Why do stocks suffer when interest rates rise?


US Stocks Forecast:

  • A sharp rise in U.S. Treasury yields coincided with a sharp drop in major U.S. stock markets.
  • Rising interest rates reduce the net present value of future cash flows according to the traditional discounted cash flow model.
  • Companies with heavy debt burdens and low (or no) profitability tend to suffer the most during periods of higher interest rates.

Recommended by Christopher Vecchio, CFA

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A changing macro-environment

Much of 2022 has proved challenging for risk assets. US stock markets led by Nasdaq 100, down about -30% year-to-date (if not more). The finger-pointing to find guilt was intense. This is because of the Federal Reserve’s misguided actions on inflation; or the Russian invasion of Ukraine. Or China’s zero-spread strategy for COVID-19, which upended the global supply chain; or the huge financial costs incurred in the first months of the pandemic.

The truth is, while stories abound, the root cause is pretty simple, if not widespread from a fundamental macro perspective: rising interest rates. Whatever the reason for the rise in interest rates, it is not the topic of discussion per se, but how the rise in interest rates affects the risk appetite of investors and traders in the financial markets.

Fed model

In the post-World War II era, US equity markets had higher annual returns than US Treasuries. However, stocks also carry more risk and thus returns have been more volatile. In particular, the standard deviation of stock market returns was higher than that of the bond market.

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Understanding the stock market

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While stocks carry additional risk compared to bonds, the expected excess return of stocks over bonds makes them a potentially more attractive investment target. One way to measure this trade-off is to use the Fed’s model, which compares the earnings yield (E/P; the inverse of the P/E ratio) S&P 500 to the 10-year US Treasury yield.

As long as broader stock market returns remain higher than bond returns, the implication is that investors will prefer stocks to bonds. However, if the S&P 500’s yield falls below the 10-year US Treasury yield, why would investors take on additional risk for lower returns?

US NASDAQ 100 (ETF: QQQ; Futures: NQ1!) vs. US 10-Year Treasury Yield TECHNICAL ANALYSIS: DAILY CHART (October 2021 to October 2022) (DIALOG 1)

Thus, the rise in US Treasury yields through 2022 has provoked a rethinking of how people allocate their funds: bond yields are comparable to those achieved in the stock market, and depending on one’s own risk tolerance, rising bond yields may be attractive enough to force a change in asset allocation.

Future cash flows lose value

But the decline in US stock markets during a period of higher interest rates is not only due to the relatively more attractive yields of the bond market. We need to open our Finance 101 textbook to get to the heart of the matter: the discounted cash flow (DCF) formula.

Discounted cash flow formula

The DCF formula measures the cash flows in different years and discounts them by the expected interest rate over that time period to find the net present value of all future cash flows: CF cash flows appear; p – interest rate; and n it is an interval in time. Notice how p is in the denominator: This means that as interest rates rise, so does the net present value CF decreases.

Therefore, in an environment where interest rates, as defined by US Treasury yields, are rising, the future cash flows that the company generates are worth relatively less today. For companies that are part of the US stock markets, rising interest rates mean that they theoretically earn less in the future. If a company is going to make less money in the future (in present value), then its capital is worth less. And if his capital is worth less, the value of his shares suffers.

This relationship is particularly bad for small, young companies with relatively minimal cash flow, and especially bad for companies that are not currently cash flow positive. Companies that are still in the early stages of growth, those seeking to make advances that will change industries or the economy — such as emerging technology stocks — tend to suffer even more because they don’t have significant cash flow and can carry a large deal. debt

Long or short?

Stocks, by their very nature, are generally considered “long-term” assets. Conceptually, duration can be reduced to this: If I deposit $1 today, how long will it take to get my money back? As interest rates rise, assets with longer durations tend to suffer more; the net present value of future cash flows declines, so it will take longer for the company to return the $1 you invested today.

We discussed earlier why ARKK Foundation Kathy Woodwhich consists of investments in companies that are typically founded recently, have just gone public, do not have significant established revenues and cash flows, and do not have significant pricing power in their industries, so underperformed in the first six-plus months of 2022 .ARKK is mainly invested in assets with the longest duration in the market!

The DCF formula summarizes ARKK’s problems, as well as the problems of the broader stock market, specifically the Nasdaq 100 technology index: Companies don’t have much (or any) cash flow, and when interest rates rise, their net present value falls quickly.

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— By Christopher Vecchio, CFA, Senior Strategist


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