Rising rates have spooked the market … why it’s not as bad as it seems … the coming resurgence of hypergrowth market-leaders … why “buying the dip” is Luke Lango’s advice
This was CNBC’s morning headline from this past Friday …
They’re a bit of a financial boogeyman … a bull-market-murderer that strikes swiftly and mercilessly.
Yes, in recent months, rates have been rising — and fast.
Last Thursday, the yield on the 10-Year Treasury Note reached as high as 1.6% before settling back.
As I write Monday morning, the bulls are back in control and rates have retreated. The 10-Year is yielding 1.42%. Yet, this is still miles above where yields were as recently as the summer.
For example, in early August, the 10-Year yielded just 0.5%, meaning it has soared more than 200% in less than seven months (before its recent pullback).
Now, some readers might be asking a question — the same question that our hypergrowth expert, Luke Lango, has been receiving from friends and family over the past week …
“Why does the 10-year Treasury yield have anything to do with the stock market?”
We’re all reading in CNBC and Fox Business articles that stocks are plunging because the 10-year Treasury yield is rising.
Those pieces usually give some cursory explanation like, “higher interest rates put downward pressure on stock market valuations.”
But what does this actually mean?
That’s what Luke will answer for us today.
Genuinely understanding the answer is important because it explains why many hypergrowth stocks have been falling off a cliff recently.
But, as Luke will also show us, this market reaction is overblown — and the recent market weakness has resulted in many hypergrowth stocks now being undervalued.
Really? In today’s market — one of the most expensive in history? How is that possible?
Let’s find out.
***Why a climbing 10-Year yield terrifies some investors
For newer Digest readers, Luke is our hypergrowth expert, and the analyst behind Innovation Investor. His specialty is finding small, market-leading tech innovators that are pioneering explosive trends.
It’s a lucrative approach to the markets. To illustrate, in just the past five years, Luke has recommended 17 different 1,000%+ gaining stocks. Most investors never enjoy even one such 10X-winner.
Returning to the issue of rising rates, here’s Luke to break things down for us:
Stocks and bonds are competing investment vehicles. That is, your money can go to work in either stocks, or bonds. The difference, of course, is risk and return.
For the most part, bonds are less risky, but offer less return. Stocks are riskier but offer more return.
Thus, when investing in a stock, you’re going to require an additional expected rate of return over a bond’s expected rate of return to account for the additional risk you are undertaking when investing in the stock.
In finance, this additional rate of return is called the “equity risk premium.”
Thus, the expected rate of return you require for a stock is equal to the expected rate of return you require for a bond plus the equity risk premium.
Luke’s mini-MBA lesson continues as he references the “capital asset pricing model,” called CAPM for short.
The model holds that: Ri (Cost of Equity) = Rf (Risk-Free Rate) + ERP (Equity Risk Premium)
***So, where does the 10-Year Treasury fit into all this?
Back to Luke:
Treasury notes are considered as risk-free as it gets. They’re basically bonds backed by the U.S. government.
So, as a proxy for the risk-free rate, investors and analysts often use the 10-year Treasury yield.
Therefore, the cost of equity equals the 10-year Treasury yield plus the equity risk premium.
The 10Yr Treasury yield is rising sharply right now. That means the right-hand side of the above equation is rising sharply. By the law of mathematics, that means the left-hand side has to rise sharply, too.
Thus, as the 10-year Treasury yield has climbed 50 basis points over the past month, the cost of equity has theoretically risen 50 basis points, too.
As the cost of equity moves higher, the present value of stocks moves lower. That’s because the present value of a company is equal to its future cash flows, discounted back by the cost of equity.
As the cost of equity moves higher, the lower its present value goes.
That’s the math behind this whole phenomenon.
In short, the higher the 10-year Treasury yield goes, the higher the cost of equity goes, and the less a company’s future cash flows are worth today.
Luke explains that this dynamic has a more severe impact on growth stocks than value stocks. That’s because value stocks have less of their value riding on future cash flows than growth stocks; therefore, their present valuations are mathematically less impacted.
And that’s why even top-tier hypergrowth stocks have been taking it on the chin over the past two weeks.
Fortunately, this isn’t the end of the story …
As Luke points out, this whole selloff has been overblown.
***Rates won’t rise forever, and hypergrowth stocks will resume their upward march
Let’s return to Luke:
Rates may be rising now off of historic lows. But they’ll stop rising, soon, and settle down at levels much below their historically average levels.
That’s because of automation and globalization.
Automated technology is capable of replacing millions of jobs today. Think language processing software automating call-centers and customer service reps. Think self-check-out kiosks automating cashiers. Think telehealth platforms automating front-desk folks at hospitals.
Technology has advanced to the point of being ready to replace millions of jobs. At the same time, thanks to Covid-19, more and more enterprises are comfortable with adopting these technologies. The result is that, over the next few years, we are going to see huge and permanent job loss in some sectors of the economy.
That’s an enormous deflationary force.
As to Luke’s second point on globalization, he writes that the global geopolitical stage is now set for globalization to come back into the spotlight. He expects companies to aggressively outsource labor and production.
This will keep consumer prices low.
Here’s Luke for the takeaway of these two forces:
Long-term, then, we are stuck in a lower-for-longer situation when it comes to interest rates.
We will likely have a 10-year yield that — by the end of the year — is hovering around 2.5% and will thereafter struggle to move much higher.
***So, what would a 2.5%-rate environment mean for the stock market, and select hypergrowth leaders?
To answer this, Luke looked back at the relationship between interest rates and equity valuations dating back to the 1980s.
He found that the 10-year Treasury yield has averaged a 100-basis-points divergence with the S&P 500’s trailing twelve-month earnings yield.
So, if the 10-Year yield hits 2.5% at the end of the year, history suggests that an appropriate trailing-earnings-yield in the stock market would be about 3.5%.
(For any readers unaware, an earnings yield is the inverse of a price-to-earnings ratio.)
That would equate to a trailing-earnings-multiple of around 28X.
Let’s return to Luke:
Call it 25X to be conservative.
Earnings estimates for 2021 are presently hovering around $170. A 25X multiple on that implies a 2021 price target for the S&P 500 of 4,250.
We sit at 3,800 today.
So … the math here says that stocks are already fully priced for much higher interest rates … meaning that this dip is little more than a buying opportunity.
Luke notes that this is especially true for hypergrowth stocks, since their decline has been more pronounced.
In fact, he suggests that many of them are now significantly undervalued — even after accounting for higher rates.
(To find out which hypergrowth stocks fill Luke’s Innovation Investor portfolio, click here.)
Here he is to wrap things up for today:
Big picture: Ignore the interest rate noise.
It’s ephemeral and overstated. Get your shopping list ready.
Come July, you’ll be wishing you had bought this dip.
Have a good evening,