June 3, 2024

Scary, Scary Interest Rates

Authored by Louis Stevens

Throughout 2024, I've noted that the 2 year and 10 year treasury yields have once again been on the rise, and that the market would eventually work to price in these higher rates. Today, we will explore what I've meant by this line of reasoning.

Importantly, as I've often shared, this does not happen instantaneously: The market usually requires a few months or quarters to fully price in the shifting interest rate landscape.

So, while interest rates began their rapid ascent in January of 2024, this reality is only now being fully priced into various pockets of the market; namely, software in recent weeks.

In the following bullet points, I will share with you the mechanisms underlying higher rates = stock prices declining. Let's begin.

Here are the three mechanisms by which higher rates pull down on stock valuations, and, by extension, stock prices:

  1. Higher rates make the yield on cash more attractive, siphoning demand away from equities and ultimately causing equity prices to fall to the extent that they become more competitive with the risk free yield on cash. As the, for instance, 2 year treasury yield increases, this makes it more attractive, naturally, which draws demand away from equities (stocks) and into bonds. With lower demand for equities, in accordance with supply and demand laws, equity prices must fall to reach supply-demand equilibrium at which price stability is reached.
  2. Higher rates cause economic growth to slow, and slower growth creates lower valuations, all else being equal. Consider for a moment the impact of higher credit card interest rates: Participants within an economic system will have far greater ability to spend using a credit card when its interest rate is 5% vs 25%. At 25%, an individual's ability to spend on a credit card becomes hampered relative to their ability to spend on the credit card when its interest rate is 5%. Extrapolate this dynamic to every corner of the economic system, and you can see how, like a series of dominoes toppling over, higher interest rates slower economic activity and growth. Slower economic growth, in accordance with the four elements of equity value (stock value) that I often share with you, causes stocks to be priced at lower valuations.
  3. Higher rates can cause economic turmoil, threatening the durability of a given company's free cash flow (loosely synonymous with earnings), and lower free cash flow durability, all else being equal, must be reflected in a company's valuation via compression of said valuation. Also in accordance with the four elements of equity value, lower earnings durability results in a lower valuation, and a lower valuation is achieved via stock price declines (or long, long periods of price stagnation).

With these three factors in mind, we better understand how higher rates have pushed downward on stock prices.

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