January is off to a no good, very bad, terrible start to the year. We’ve seen three consecutive down weeks and some very painful corrections in individual names like Zoom, Peloton, and Moderna, who are all down more than 40% from their 52-week highs. Why is there such a bloodbath in stocks right now?

The major downward movements are due almost entirely to comments coming from the Federal Reserve. The Fed is accelerating its tapering (i.e. how quickly they wind down their bond purchases that provide cash and liquidity to markets) as well as forecasting what could be 3-4 interest rate hikes this year. These moves are meant to beat back the rampant inflation that’s gripped the economy; eight consecutive months with a reading above 5% and a 7% reading in December – the highest in a full forty years. Taming inflation is important but painful. The remedy will not be easy.

Interest rate hikes impact all areas of the economy, from housing prices to bond yields and even stock prices. The impact on housing and bonds is relatively straightforward, but stocks? The impact is there, too, but it’s baked into to some fundamental assumptions in modern finance that aren’t as obivous.

The Cooling Off Effect

First and foremost, there is the “cooling” effect that higher interest rates have on the economy. Everything that entails financing gets just a little more expensive. It becomes less attractive to buy a house due to the higher monthly payment on the mortgage. The same goes for cars, boats, and yes, even college. Adjustable rate mortgages increase in cost, snapping back the purchasing power of a contingent of consumers who could have used that money on other goods and services. Financing costs for corporations increase as well. They’re less likely to invest in new factories and equipment. Consumer sentiment tends to dampen as people realize the avenues for growth aren’t quite what they used to be.

Lower Discount Rates

Second, higher interest rates reduce the discount of the present value of future cash flows. This one doesn’t make for quick and easy dinner conversation. Theoretically, an asset should be worth the sum of all its present and future cash flows. Businesses that are expected to earn lots of money are naturally worth more than those that are expected to tread water. But its hard to assign a value to just how much the future cash flow of a profitable company is worth today. That’s why the financial world assigns a discount rate to those future cash flows. A dollar today is worth more than a dollar tomorrow, so those future dollars must be discounted.

If you as an investor “demanded” a 5% return, you would be willing to pay about $61 to receive $100 in ten years. You discount the value of that future $100 to a price you’re willing to pay today. But how did you determine that 5% figure? Would you use that 5% to evaluate AAA-rated bonds as well as Bitcoin? Probably not. Bitcoin is so much more volatile! The discount rate applied to future cash flows therefore depends on how risky it is to wait for them. We should demand a higher return on Bitcoin and therefore a higher discount rate.

But this discount rate isn’t just a function of personal preference. Prevailing interest rates and other alternatives factor in as well. There’s always an opportunity cost to the investment decisions that you make. When safe alternatives (treasuries) start paying more, then your risky investment needs to pay more as well. When interest rates rise, so must the discount rate.

And the higher the discount rate, the lower the resulting present value! Think about the last example in which you were willing to pay $61 today for $100 in ten years at a 5% discount rate. If that rate moves up to just 6%, the amount you’d be willing to pay today would decrease to $55!

When you apply this to stocks, the values must decrease all else being equal due to the higher rates and more attractive alternatives.

Higher Capital Market Line Assumptions

Third, a higher risk-free rate brings up the return assumptions along all areas of the capital markets line. If you had to plot out risk/reward on a graph, some asset classes would be high risk/high reward while others would be low risk/low reward. Then you have everything in between as you move from low risk (treasuries) up to high risk (bitcoin, for example). The upwards sloping line going from low-risk assets to high-risk assets is called the capital market line.

The 30-day Treasury Bill is often referred to as the risk-free rate of return. It’s assumed that the US government will never default on debt due at the end of the month since it can print all the money it needs for repayment. Moreover, the maturity date is so close that there’s no risk of losing purchasing power. It’s the lowest point on the capital markets line and therefore the starting point to the capital markets line.

Since you can earn this return with zero risk, anytime it shifts upwards or downwards the rest of the line must shift with it. If the next least-risky asset paid less than the risk free rate, why would you ever buy it? The answer is you wouldn’t, which is why that asset and everything coming after it must also pay more when interest rates rise. The entire line shifts upwards following an interest rate hike.

So, increasing interest rates means that all assets must now earn more to justify their current price. That, or reduce their price to make them more attractive relative to their risk-free peer.

Lower Valuations

Fourth, higher demanded returns lead to lower demanded valuations. See the last sentence from the third point immediately above. This is also known as “multiple compression” from the namesake of this article.

If interest rates are a paltry 1%, you might demand a 6% return for investing in riskier stocks. This represents an “equity premium” of 5% for investing in stocks over treasuries. You can get the 6% demanded when earnings are 6% of the stock price, or 6/100 of the price if we write it out as a ratio. This earnings/price ratio listed in this example is just the inverse of the well-known price/earnings ratio, which would be 100/6 here. That 100/6 works out to 16.6, which is often called “the multiple”.

Now assume that interest rates climb to 2%. You must now demand a 7% return to keep the same equity premium (5% in this example). That means earnings must now represent 7% of the stock’s current price, or 7/100. The price/earnings ratio inverse is 100/7, or about 14.3.

Note how that multiple reduced when interest rates rose? All else being equal, the stock price must adjust downward to justify the higher demanded returns. This phenomenon is known as multiple compression and is reduces the valuation we place on stocks.

Tapering impacts stock prices, too

Fifth, the Fed has the ability to increase yield by stopping its purchases of bonds (tapering). This is just a knock on to the fourth point listed above. The Fed has been a massive purchaser of bonds for the last two years, which has created big demand for bonds and driven up prices. Winding this down will mean a decrease in demand. This leads to a decrease in price, which drives up the yield. (Bond prices and bond yields are inversely correlated).

The increasing yield means that other asset classes must work harder to attract dollars from investors. It’s opportunity cost. In the case of stocks, this means lower prices.

Reduced Risk Tolerance

Sixth, higher rates encourage reduced risk tolerance and less speculative behavior. As the capital market line shifts upwards, investors may be willing to move to less risky asset classes in order to achieve their desired rate of return. For some this will mean moving out of stocks and into bonds, which reduces demand for equities and further drives down stock prices.

Again, its an issue of opportunity cost. Stocks were just about the only place to put money for the last couple of years given how low interest rates were. But more attractive alternatives are right around the corner, and investors are repositioning portfolios now in anticipation of this.

Opportunity Costs

Seventh, the need to put money to work diminishes as viable “parking spots” open up in the face of higher-yielding debt. This closes a few doors in capital markets. Banks will find it more attractive to keep their reserves over loaning them out, which restricts the flow of money through the economy. Speculative, high-risk projects won’t be funded. Neither will investors with poor credit.

The “credit window” closes just a bit and shuts out the current highest-risk parts of the market every time rates rise. This forces high-risk assets, like stocks, to decline in price.

Bringing it all together

Interest rates are baked into every nook, cranny, and facet of modern finance. Even assets that don’t seem to have a clear connection are invariably impacted when rates rise. Stock valuations must come down when rates rise. But, the repricing that takes place is a temporary event. The structural underpinnings of the economy are still there, and companies will continue to make money. This means the earnings portion of the price/earnings ratio will increase and ultimately drive stock prices higher, though it won’t happen overnight.

This may be why speculative growth fund manager Cathie Wood of ARK funds said she sees 40% upside for her funds over the next five years. Stocks will eventually find a bottom at which investors finally feel comfortable. Multiples will climb from there.

In the near term, multiples may compress further as stocks continue to reprice. The economy at large will grow as will corporate earnings, but probably at a slower pace than what we saw over the last two years. Lower highs are also likely as we approach more normal market conditions and normal return expectations (i.e. not 20%+ each year). Growth stocks, which sit at the highest and riskiest end of the capital markets line, will have the hardest fall. Defensive stocks will likely fare better this year.

Finally, nothing has actually changed yet apart from tapering. Interest rates have yet to move. The sell-off is entirely speculation at this point, which means the Fed hiking rates just twice this year instead of three times will lead to a nice rally. Be patient. Nothing has changed in the economy. Everything that’s happening is due to changing expectations. This, too, shall pass.


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