There’s an indirect influence on interest rates and stock prices. The Federal Reserve has pledged to keep short-term rates, which it controls, lower for a while, to combat the economic reverberations from the pandemic. But long-term ones, as exemplified by the benchmark 10-year Treasury note, have trended upward over the past month, only sliding a bit last week. (The Fed doesn’t oversee these.)
What does this rising-yield phenomenon tell us about equities going forward? We asked Nicholas Atkeson and Andrew Houghton, the founders of Delta Investment Management in San Francisco.
Larry Light: First off, there’s a big disparity between the tech-oriented market leaders and the rest of the stock market.
Nick Atkeson: Yes. Stocks are categorized by size, as in small versus large, and type, namely growth versus value). During 2020, large capitalization growth stocks significantly outperformed the rest of the stock market. Year-to-date through Nov. 9, the five largest stocks, all growth stocks, of the S&P 500, are up collectively 48% versus the remaining 495 stocks, which are up 4%.
This month, two major stock moving events took place. The first was the presidential election on Nov. 3, and the second was the announcement of a COVID-19 vaccine before market open on November 9. The 10-year U.S. Treasury rate reacted strongly to both events, but in opposite directions. It fell 15% in the wake of the election, Nov. 3 through Nov. 6, and then rocked up 28% on the vaccine news, Nov. 6 through Nov. 10.
Light: And interest rates had a bearing on the stock market?
Andrew Houghton: The dramatic fluctuations in interest rates during November created some of the strongest divergences in stock price performance we have ever seen. They offer a crash course in how changes in interest impact different types of stocks differently. The relationship between interest rates and stock values helps us consider how we might optimize our positioning for 2021.
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Light: One part of that equation is that the level of interest rates affects the discount rate, which affected the value of a company’s future net income.
Houghton: High multiple growth stocks discount decades worth of future earnings. For example, Apple AAPL is trading at a current year price/earnings multiple of nearly 37. If earnings remain flat, it would take investors 37 years to recoup their investment. By contrast, Bank of America BAC is trading at a P/E of 13. The longer the duration, the higher the interest rate sensitivity.
Light: And November has shown us some big moves in the 10-year T-note yield.
Atkeson: From the start of 2020 to the beginning of November, the 10-year Treasury declined from 1.9% to 0.6%. Falling rates and an accelerated trend to online commerce generally drove large-cap growth stock outperformance. Going forward, rising rates and a full reopening of the economy may cause value stocks to outperform.
Light: Inflation is a factor here, right?
Atkeson: Inflation is currently running at about 1.6%. With the 10-year Treasury yield at 0.9%, the real interest rate is negative 0.7%. Negative real interest rates have not persisted historically. We should expect the nominal 10-year Treasury rate to eventually exceed the inflation rate. Over the next year or two and assuming inflation remains about where it is, the 10-year Treasury rate could climb back into the range of 1.5% to 2%.
Light: What does that mean for stocks? Usually, higher rates aren’t good news for equities. But not this time, eh?
Houghton: Companies with strong secular growth tailwinds and leading market positions should continue to do well. What also may do well, especially relative to year-to-date performance, are oversold value stocks that offer attractive yields and improving business metrics with a reopened economy.