Stocks had a mixed close yesterday as recently depressed tech shares led the market higher. Bond yields are causing nosebleeds, but maybe it is not so bad after all.
Didn’t you know? After these past 2 years, I am sure that you consider yourself somewhat of an expert when it comes to how interest rates impact your stock investments. Humor me for a moment. Think back to 2018… go on… keep thinking. Try to remember the relationship between stocks and bonds. Did you go to business school? Perhaps you are self-taught through careful study of the financial press and some highly recommended books. All of those are great ways to prepare yourself for being an informed investor. In 2018, we knew that one of the basic tenets of the markets was the INVERSE relationship between bonds and stocks. When stocks go up, bonds go down and vice versa. The rudimentary explanation is that when the stock markets get agitated, investors seek safe harbor in bonds, so bond values go up with the increased demand and, subsequently, bond yields come down. That’s it! Simple. Of course, we know that there are many other factors like competing yields and so on, but the basic inverse relationship is supposed to be the bedrock on which all is built on. Now, I am sure that you also know that the inverse relationship is not perfect, but still, at the most basic level, it should hold, right?
Right… right up until, well, recently. You see, all that seemed to change once the threat of the Fed raising interest rates began with the emergence of the recent inflation pandemic. If you are a regular reader, you know that I often mock my own profession as a financial quant. I am the guy that, you know, boils everything down to the numbers. I first plied the keys of my HP 12-C calculator (which still sits on my desk) in 1986, when I calculated my first present value. THAT is how one comes up with a fair value for a stock, it is the present value of the company’s future cash flows, earnings, dividends of whatever the analyst chooses to use, but one thing does not change and that is the equation’s reliance on prevailing interest rates. I won’t get into the math because it is too early in the week, but I will tell you that, mathematically, when interest rates are higher… mathematically, the present value goes down. Every freshman business major is taught this equation and most forget it by the time they receive their diplomas. The ones that go on to become analysts, AND QUANTS , use the very same equation on a daily basis, though it is most effective in determining the value of a NON-EXCHANGE-TRADED investment or project proposal. Why not for exchange-traded? Because we have the market to sort all that stuff out. Apple’s stock closed at $175.84 yesterday, which means that the company’s market cap is $2.759 trillion. Do you think you can do better than the market at determining that with a hand-held calculator?
Don’t worry, many really smart people are digging through oppressively large spreadsheets and fashioning them into something that reveals a target number somewhere slightly higher or lower than $175.84. If it is higher, they will tell you to buy it and if lower… well, sell it… or maybe, just hold on to it. On those spreadsheets, in that one cell on the first tab is a yellow-highlighted number for the analyst to fill in, and wouldn’t you know it, that number, the discount rate, is directly related to interest rates and bond yields. In case you missed it, those have been going up since March of last year. So, someone in late 2021 decided to spoil everyone’s party and sound the alarm that if interest rates were to go up, Apple may suddenly be worth less. HUH?? All those iPhones, music streams, cool earbuds… all those potentially cool things Apple has yet to even reveal, are suddenly worth less because the Fed is raising interest rates to combat inflation? That is the theory, and the market bought into it. I know that this is sounding blasphemous for me, a finance expert, but I am also a student of the markets, and I also know that the market, not an HP calculator is the ultimate judge of a stock’s value.
Right now, the market believes that stocks are overbought and that bond yields should be higher due to the stronger-than-expected economy, still existent inflation, a Fed determined to keep rates higher for longer, and the deluge of treasury supply hitting the market. That makes stocks go down AND bonds go down in a correlated fashion. You can believe that interest-rate-sensitive stocks are going down because of the higher bond yields and their impact on the present value formula , or you can just trust the market. That might help you better understand why, despite what you know about theoretical finance, bond yields hit highs not seen since 2007 yesterday and tech stocks rallied. Perhaps tomorrow I will share with you the chart which I prepared earlier this morning that shows the correlation between stocks and bonds going back to 2000 and how it changed materially since 2021. Perhaps, not… you don’t need it.
WHAT IS HAPPENING?
Lowe’s Cos Inc (LOW) shares are higher by +2.63% in the premarket after the company announced that it beat EPS estimates. The company reaffirmed its full year guidance, pleasing analysts. The company attributes last quarter’s success to strong demand from professional contractors and online sales. Dividend yield: 2.02%. Potential average analyst target upside: +8.8%.
Dick’s Sporting Goods Inc (DKS) shares are lower by -18.9% in the premarket after the company announced a significant EPS and Revenue miss. The company attributed the decline in soft growth of sports apparel and it lowered its full-year guidance. Shares of NIKE are lower by -2.05% on the news. Dividend yield: 2.71%. Potential average analyst target upside: +6.5%.
YESTERDAY’S MARKETS
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