Recently, there has been chatter that rising interest rates are the culprit for turbulence among high growth stocks which saw huge gains in 2020. This follows a recent selloff in tech stocks which coincided with a fairly rapid rise in the 10-year US treasury rate.
At the same time, what most people haven’t heard is that a substantial amount of the gains achieved last year were attributable to decreases in interest rates which were used to stimulate the economy during the downturn last spring.
Of course, these firms are growing, which is why they’re considered growth stocks to begin with. Many of them, in fact, are investing so heavily in growing their businesses that they aren’t currently profitable, and may not be for quite some time.
Growth stocks and US Treasury bonds serve very different purposes within one’s portfolio, so why are these two connected to one another?
It’s because the stock price of any firm is the present value of its expected future earnings, and the 10-year US Treasury rate is a key input used to calculate the value of stock prices.
Because US Treasury bonds are perceived to have no risk of default (i.e. not being repaid), the interest paid to people who invest in them is low because they aren’t being compensated for the risk that they won’t be repaid.
Instead, they are being paid interest to compensate them for the amount of time until their money is returned to them.
This is also why US Treasury rates are also referred to as the “time value of money.”
So how exactly are the two connected?
The value of a company’s stock is the sum of all of its expected future earnings, and because future earnings don’t arrive until the future, they are discounted using the 10-year Treasury rate to estimate their current value.
Of course, this also takes into account a firm’s expected growth rate, as well as a “risk premium” which compensates the investor for the perceived level of risk that things may turn out differently.
In other words, if we’ve decided what a company’s future earnings will be, calculating their present value is effectively using compound interest in reverse (discounting them to the present, as opposed to growing them to the future value).
Why is it that the fastest growing firms are most affected by this?
That’s because many of the fastest growing firms are highly unprofitable in their current form, and in some cases, this may persist for some time.
If they really needed to be profitable today, most would have to dramatically reduce what they spend on growing their business.
And for firms that are growing rapidly but currently unprofitable, this means that the entirety of their stock price is driven by earnings that will occur far off into the future.
That’s why the faster they are expected to grow, and the further out in time that is expected to take place, then the more they are highly sensitive to the inputs used to calculate their stock prices.
Again, think of this like compound interest in reverse, so when the 10-year rate used to calculate the present value of those future earnings starts to increase, the value of those future earnings starts to decline.
The opposite of this is “value stocks” which are broadly considered to be firms that are currently profitable, but have low to moderate growth expectations.
Banks, cable companies, and electric utilities all fit this bill, and that’s why this is less of an issue for them.
Ultimately, what’s most important is to know what you own, and why you own it. If you don’t, it’s probably time for a second opinion to make sure your money is working hard for you.
Download this checklist to see the 10 signs that it may be time for a second opinion.
This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.