The battle and the war

Stocks posted minor gains yesterday amidst hot debate about what the Fed might do next. Existing home sales hit a post-pandemic low – bad news for the economy, but good news for inflation.

This is, perhaps, the end of the beginning. If you are of a certain age, you may recognize that tagline. If you aren’t or you don’t, I will cut through the suspense. It is part of a larger but very famous 1942 quote from Winston Churchill. There are many interpretations of that quote, but I think of it from time to time when I feel as if I must remind myself to stay alert, despite a rise in calming forces.

Have you noticed that some of your more growthy equities have come back a bit lately? Of course, you have, you are focused on your wealth, as you should be. When you notice the improvement, you are likely to have uttered some sort of elated thanks to some higher being or another. I am with you…for the record. But what is it that put a halt to the painful drawdown in everyone’s favorite growth stocks, and caused them to start the long, hard climb back to last year’s prominent levels? Well, like it or not, interest rates played a very prominent role in the state of growth equities since later last year. Check out these charts of the S&P500 Growth Index and 2-year Treasury Note yields for a very graphic, but suitable for work, depiction.

In the top panel, we see a precipitous fall in growth equities starting last November and bottoming out in late June of this year. In the bottom panel, we observe that short-term Treasury yields climbed steadily from Q4 last year through mid-June of this year. From this, it is clear that there is a strong inverse relationship between bond yields and growth stocks. Taking it further, once yields began to stabilize around that 3.25% level, growth stocks began to climb.

Now, it is true that a high-interest rate environment puts pressure on corporate earnings as borrowing costs go up. This alone will have negative impact on a stock’s value that is largely based on earnings – less of those means a lower stock price. Adding to that pressure is a stock’s intrinsic value which is mathematically dependent on interest rates in not only discounting future cash flows, but also long-term growth (terminal value) value. These higher yields, mathematically reduce the present value of future earnings, which for a growth stock is the primary reason for investors’ interest. We expect…um, growth from growth stocks.

We all know who controls short-term interest rates, right? Indeed, that would be the Federal Reserve bank. You see, 2-year note yields attempt to reflect where the market believes short-term interest rates will be within the next 2 years. As the Fed became more aggressive in its jawboning and rate-hiking, so did the prospects for higher short-term rates…AND LOWER GROWTH EQUITY VALUATIONS. So, we know that, unfortunately, growth stock prices, despite their performance, are going to take cues from the Fed and its path of interest rate hikes. Harder and faster will hold back any future rallying and perhaps even cause drawdowns, while conversely, more cautious behavior could pave the way for further gains.

Next month, the Fed will meet, and they are likely to raise interest rates by at least +50 basis points, based on market expectations built into the future market. HOWEVER, the probabilities for an even greater increase have been on the rise, albeit slowly.  Yesterday featured a packed schedule of Fed speakers – you know, the folks who will vote on those hikes next month, and their rhetoric was anything but dovish, which contrasts with not only the current general market narrative, but also the recently bullish march in growth equities. We are all hopeful that inflation will continue to ease, that the Fed can stick to its current hiking plan, and that the economy can withstand all these gyrations without falling into a painful recession. We also know how difficult that will be to navigate. The most important thing is to remain vigilant and not be lulled into a state of misplaced bliss. “Now is not the end. It is not even the beginning of the end. But is, perhaps the end of the beginning.” Winston Churchill, 1942, on his comments about the second Battle of El Alamein. The war in Europe would end almost 2 years after Churchill made that speech.

YESTERDAY’S MARKETS

Stocks posted modest gains yesterday amidst a backdrop of hawkish Fed comments and missed housing numbers. The S&P500 gained +0.23%, the Dow Jones Industrial Average traded higher by +0.06%, the Nasdaq Composite Index rose by +0.21%, and the Russell 2000 Index advanced by +0.68%. Bonds gained and 10-year Treasury Note yields fell by -1 basis point to 2.88%. Cryptos climbed by +0.53% and Bitcoin advanced by a scant +0.4%.

NXT UP

• Next week: Another week of very critical retail earnings announcements. Additionally, we will get flash PMIs, more housing numbers, more regional Fed reports, Durable Goods Orders, GDP, Personal Spending, University of Michigan Sentiment, and MOST IMPORTANTLY, the PCE Deflator, which is the Fed’s preferred proxy for inflation. Check back on Monday for calendars and details.