Interest Rates & Tech Stocks

On the last day of last year, the 10-year US Treasury closed with a yield of 1.52 percent. As noted above, it closed last week with a yield of 1.78 percent, an upward change of 0.26 percent, or in percentage terms, 17.1 percent higher.

Short-term rates have not changed much so far, but the Federal Reserve has indicated that short-term rates could be at or above one percent by the end of this year.

It’s not surprising, therefore, that bond prices would be lower, that’s just math. (Although let me reiterate that, as bond investors, we want interest rates to go higher. It hurts in the short run, but we want to earn more on our money).

What is more surprising in my opinion, is that technology stocks, and growth stocks in general, have lost so much ground and the story is that interest rates are to blame.

So far this year, the S&P 500 is down -2.1 percent, but growth stocks are down -5.1 percent. Technology stocks, which make up 40 percent of the S&P 500 growth stock index that I’m using, are down -4.7 percent.

The theory that I hear bandied about is that higher interest rates are hurting growth and technology stocks. To understand why that might be true, let’s take a step back.

The fundamental idea behind any investment is the present value of its future cash flows. Therefore, to find the present value, you need the future cash flows and a discount rate to discount those future cash flows to the present.

And that’s why stocks are so hard: we don’t know the future cash flows and we don’t know the discount rate.

But when stocks are really expensive, like tech stocks today, it is reasonable to infer that investors expect a lot of growth and the distant future cash flows will be more than the nearer-term cash flows.

Said another way, okay, these stocks aren’t making a ton of money and may not in the next two or three years, but they will grow so much that the earnings 10-years from now will be off the hook (do people still say that?).

I’ve heard it said that growth stocks are companies whose value is based on investments not yet made, and while that differs from the original academic meaning, I kind of like it.

If we accept the idea that the earnings are way off into the future, then it does stand to reason that higher interest rates will make that cash flow less valuable today.

As a value investor, I want this story to be true. I’ve been in the wilderness with value underperforming growth for what feels like forever (though it’s really a few years, which in investing time, isn’t all that long).

As someone that appreciates data and history, here’s why I’m not sure that I buy this story.

In July 2017, the yield on the 10-year Treasury was 1.5 percent and started to head higher after falling for the previous few years. It peaked in October 2018 at 3.0 percent. Yep, it doubled in a little more than a little less than 18 months.

And, unfortunately for a value investor, it was not a boom time – it was just the opposite. While value stocks did well earning 9.8 percent annualized, growth stocks did a heck of a lot better, up 17.0 percent. Tech stocks? 24.0 percent.

Hm… That’s tough to reconcile with the narrative floating around today.

Okay, if that’s not what’s going on, what is? I have to claim ignorance here because I don’t know.

I think it’s possible that valuations just got a little too high for growth stocks.

I often hear people say, ‘at some point,’ this will happen or that will happen – debt will get too high, or stocks will get too expensive. And yes, at some point, all of those things may happen, but at some point, it’s just a little too hard to measure.

Perhaps this is one of those points. The people saying that investors would realize at some point that tech valuations would be too high might be right.

Or maybe this is just a little mean reversion. Over the past year, the gap between growth and value stocks was widening out quite a lot. The recent performance closed the gap a lot, although there is more room. Why now? I don’t know.

And that’s the thing about markets, you can do a lot of measuring to say what happened, but it’s a little harder to figure out why. So, for now, I’m just going to be happy that my beloved value stocks are having a lovely moment in the sun and hope that it keeps going.