rising rates…stocks and bonds (ii)

generally speaking…

Historically, the Fed begins to raise rates when the economy is operating at or above its long-term potential and people and companies are starting to act in economically destructive ways. The clear intent is to slow economic activity down. In addition, there’s never just one rate hike; it’s always the first one in a series. Perhaps most unsettling, I don’t think the Fed has ever stopped choking the economy back before triggering a recession. So a rate hike is typically a strong signal to begin to batten down the hatches, in expectation of a recession in a year or so.

Although what I’m about to write will send a shudder down the spine of any experienced equity investor, this time may well be different.

Even if so, however, the first instinct of investors, and AI-driven ones in particular, will doubtless be to run for cover.

present value

If we grant the validity (I don’t think it’s the whole story) of the predominant academic metaphor that stocks are a funny kind of bond, a rise in interest rates has a more direct impact on valuation.

Let’s take the example of a mature company (think: public utilities, consumer staples, autos…). Assume it can grow at, say, a steady 10% per year. (This is a simplification. Nothing, in my view, is recession-proof.)

The profit growth profile of a company like this over a decade is as follows:

year 1 2 3 4 5 6 7 8 9 10

income 1 1.1 1.21 1.33 1.46 1.61 1.77 1.95 2.14 2.36

The present value of this income stream when rates are at 2% is: 14.34

At 4%, the PV is: 13.03,

with, as you’d expect, most of the difference coming in the years farthest in the future. At a 4% discount rate, the PV is 9% lower than at 2%.

Now a growth stock, which we’ll assume the consensus believes will grow at a steady 20%/year. The profile:

year 1 2 3 4 5 6 7 8 9 10

income 1 1.20 1.44 1.73 2. 07 2.49 2.99 3.58 4.30 5.16

PV, at 2%: 23.27.

PV, at 4%: 20.93. At 4%, the PV is 12% lower than at 2%.

For an assumed 30% grower, the shrinkage in PV is much more severe as rates rise.

Two conclusions:

–rising rates are bad for all stocks, and

the farther in the future the earnings are that are being priced into today’s stock value, the worse the negative effect of rising rates on the price will be.

not the whole story

The difference between the stocks that a value investor holds and those in a growth investor’s portfolio isn’t just that the former have slow-growing earnings and the latter fast-growing. While this may turn out to be true, it’s not the rationale for owning them in either case.

For the growth stock investor, the motivation for owning a stock is the belief that the underlying company is actually growing at a faster rate than the consensus understands and/or that superior growth will continue for longer than the consensus expects.

A typical situation is one where today’s price indicates the market thinks a firm will grow at, say, a 20% rate for five years, before tapering back to 10% growth over the following half-decade. This, in itself, isn’t that interesting. What is interesting, however, is when the growth investor’s own analysis indicates company profits are really expanding at a 35%+ annual rate, with no end in sight. In addition, the best growth stories are of companies capable of reinventing themselves. Classic examples: Apple going from near-death to being the iPod company to the iPhone to the ecosystem; Amazon going from online books to online merchandise for others to cloud services to Kindle, Audible, Prime…

how higher rates may work out

My picture is that there may well be a knee jerk reaction to interest rate rises when they happen. Stocks as a class would decline, although not as much as bonds. Growth stocks, the bulk of whose earnings are perceived to be farther in the future than for the stock market as a whole, would likely fare worse than others. Stocks already left for dead by Wall Street might not decline at all.

The initial emotion-driven selloff would likely be followed by a reassessment, in which growth names would begin to recover. If nothing else, earnings reports would indicate both that sellers had overestimated the damage that normalization of rates would cause and that Wall Street had been chronically underestimating the earning power of the best growth names.

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