Here's a Little Story About How Looks Can Be Deceiving

What’s the line about how looks can be deceiving? That can definitely be said about this week’s market action. On the surface the broad-based equity indices put in a fairly benign performance. The headline S&P 500 index ended the week modestly higher from the week prior. Big name stocks, like Apple, Microsoft, Facebook, and Google all ended the week either moderately lower or posting small gains. But as we scratch a little beneath the surface, we can start to see some of the fault lines that caused pretty big tremors this week. The tech heavy Nasdaq 100 dropped over 1.75%, while the small cap Russell 2000 shed 0.35%. But it’s not until we dig a little deeper that we truly see the tumult that shook the broad market. While these shocks may have left the headline indices like the S&P 500 and the Dow Jones 30 mostly unscathed, these events can ultimately lead to further repercussions down the line.

At the center of this week’s drama is the fear surrounding rising interest rates. While the Federal Reserve maintains its current assertion that it does not plan any rate hikes for the foreseeable future, read 2023 at the earliest, the market, which controls longer date interest rates seems to have other plans. The benchmark 10 year US Treasury bond, which began the year yielding around 0.90%, has risen dramatically, closing the week at a rate of 1.55%. During this same period, the 30 year Treasury bond has climbed to over 2.28% from a start of year yield of 1.64%. As yields on bonds rise the price of the bond falls.

Aside from longer term effects on the economy that can arise with higher interest rates, the first knock on effect is that higher interest rates are a big negative for growth stocks. Low rates benefit growth stocks because a lower discount rate makes paying more for future earnings or revenue more attractive today. Most people don’t realize this, but when you are buying a stock you are effectively buying a future stream of earnings or revenue. When rates rise it lowers the present value of that future stream of revenue. Conversely, stocks with greater current revenue or profit tend to outperform when rates rise. The problem for the current market is that the many of the companies that control a lion share of the market cap of many of the most followed indices are growth oriented companies. Case in point, Tesla, which entered the S&P 500 late last year and, at entry became one of the top 10 holdings of the index.

The impact of higher rates on growth stocks was clearly evident by the performance of last year’s top performing Exchange Traded Fund, Ark Innovation, ticker symbol ARKK. From the market lows last March, fund manager Cathie Wood logged an impressive 379% return by February 16^th. She managed these returns by riding the impressive performance of Tesla, Etsy, and Roku to name a few. However, since that peak in mid-February, Ark has fallen off a cliff. Today, at the lows, Ark had fallen 33% from its highs. You may be saying to yourself 379% less 33% what’s a few nickels between friends. But the negative effects of volatility are on display when you do the math and realize that it actually cut the overall performance from the March lows to a still impressive, but ego deflating, 224%. Since the lows today, Ark has recovered quite a bit, but if that’s what can happen when the 10 year rate climbs from 0.90% to 1.55%, I shudder to imagine what will happen if it ever approaches 2% or 2.5%.

For now, my gut tells me we may have seen a short term peak in bond yields which should alleviate some of the pressure on growth stocks. However, with another round of stimulus checks about to head out and with a Fed that shows no sign of taking its foot off the pedal I don’t think we’ve read the end of this story. I fully believe that the stock market eventually must have a “come to Jesus” moment with the prospects of higher inflation and higher interest rates. This prospect remains our primary concern for 2021 and beyond.

Thanks for reading,

Zach and Dave

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