Rising rates cheapen stocks’ future cash flows
Whatever was ailing the U.S. stock market during the week of October 8, the rise in the 10-year Treasury yield to its highest level in seven years has contributed further to tighter financial conditions and a reassessment of price levels for risk assets, particularly technology and growth stocks.
Stocks have since pared some of their losses during the two trading sessions for the week of October 15. Yet, a look at some of the moves the previous week are worth a review.
First off, the S&P 500 index suffered its biggest two-day decline since February amid a backdrop of concerns over a Federal Reserve firmly entrenched in a rate tightening cycle, and continued uncertainty over the trade and tariff dispute between the U.S. and China. The yield on the 10-year Treasury note settled at around 3.163% on October 12, compared to a recent low of 2.820% in late August, driven, in part, by a higher term premium investors demand for holding longer-dated debt.
After shrugging off the downturn from its high in late January and continued swoon in early February, the S&P 500 finished the third quarter up by 8.99% year-to-date. But since the beginning of the fourth quarter, the index has shed 5.04% through last Friday, October 12. It’s a similar story for the Dow Jones Industrial Average, which had gained 7.04% through the first nine months of this year, and has fallen back by 4.23% since the beginning of the fourth quarter through October 12.
Technology stocks, among the clear industry leaders in this year’s strong performance for U.S. stock markets, fared worse. After delivering a price return of 16.56% since the beginning of the year through the third quarter, the Nasdaq Composite has lost 6.83% through October 12. What’s more, the S&P 500 Information Technology sector, which had been this year’s best performing sector among the index’s 11 sectors, has fallen 5.97% since the fourth quarter began. The S&P 500 IT sector had gained 19.52% during the same period.
Price returns for other high-flying performers this year were also clipped, namely consumer discretionary stocks and small-cap stocks. The S&P 500 Consumer Discretionary sector gained 19.47% through the third quarter, but has declined by 7.74% in the fourth quarter through October 12. The small-cap Russell 2000, up 10.49% through the first nine months of the year, has fallen by 8.83% since the fourth quarter began through October 12.
“Equity markets have seen a sharp rotation in leadership, with momentum shares under performing after a stretch of strong gains,” Richard Turnill, Blackrock’s global chief investment strategist, wrote in its Global Weekly Commentary. “We believe the bulk of the recent selling pressure has been driven by hedge funds unwinding popular crowded positions – especially in technology and growth names.” 1
So where do rising bond yields fit in? And what, if anything, do rising Treasury yields have to do specifically with tech stocks?
A good place to start could be a look at what had been contributing this year to higher share prices for technology companies ─ in general, the story surrounding some of the sector’s top names, and the growth and momentum investors propelling those stocks higher (something alluded to in the Blackrock commentary).
Growth investors, as the name suggests, had been buying the growth story that successful technology companies are disrupting staid industries and innovating across market sectors. Then there’s the momentum investors, not too interested in the growth story, but rather buying into the upward moving trend for technology stocks.
But as the price for technology shares escalated, it also escalated their valuations. Low bond market yields also had provided a firm foundation for the value of technology companies’ future cash flows. But with higher yields, those future cash flows are worth less because of the discount rate applied to forecasts of future income growth are now worth less. That reduces tech stocks’ present value and makes valuations less attractive.
“Given their lack of dividends and high valuations, high-flying growth stocks are arguably the longest-duration assets in the world,” Morgan Stanley’s chief investment officer and chief U.S. equity strategist told clients, according to this CNBC report. “Therefore, it’s perfectly reasonable that they would eventually succumb to rising rates.” 2
With earnings season moving into full swing, investors may be on the lookout for companies’ commentary that focuses on whether rising interest rates, higher operating costs, particularly for worker salaries and raw materials like crude oil, as well as other headwinds such as the trade wars, might impact earnings momentum.
As of October 12, the estimated earnings growth rate for the S&P 500 for the third quarter is 21.5% compared to the same quarter a year ago. There have been 80 negative earnings-per-share (EPS) preannouncements and 40 positive EPS preannouncements. That results in a negative to positive, or N/P, ratio of 2.0, up from 1.3 in the second quarter, according to I/B/E/S data from Refinitiv. 3
“We still see corporate earnings supported by sustained above-trend global growth, and retain our preference for equities over fixed income,” Blackrock’s Turnill wrote. “But we reiterate our call to focus on portfolio resilience. Companies that disappoint on third-quarter earnings and fourth-quarter guidance risk being acutely punished.”
1 Turnill, R. (2018, October 15). October’s selloff scares in context. Blackrock Global Market Commentary. Retrieved from: https://www.blackrock.com/investing/insights/weekly-commentary
2 Pisani, B. (2018, October 9). Stocks that should act like bonds are doing something unexpected. CNBC: Trader Talk With Bob Pisani. Retrieved from: https://www.cnbc.com/2018/10/09/stocks-that-should-act-like-bonds-are-doing-something-unexpected.html
3 Aurelio, D. (2018, October 12). S&P 500 Earnings Dashboard | Oct. 12. Thomson Reuters | Lipper Alpha Insight: I/B/E/S data from Refinitiv. Retrieved from: http://lipperalpha.financial.thomsonreuters.com/2018/10/sp-500-17q1-earnings-dashboard/
Sources for Financial Data:
10-Year Treasury note:
Dow Jones Industrial Average:
S&P 500 IT Sector Index:
S&P 500 Consumer Discretionary Sector Index:
Russell 2000 Index:
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