“Why does the 10-year Treasury yield have anything to do with the stock market?”
I’ve had lots of family, friends, and readers ask this question over the past week.
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 that actually mean?
You need to know the answer to that question at a very granular level, because interest rates today are driving the stock market – and they’re causing many hypergrowth stocks to fall off a cliff.
So, let’s break it down:
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.
Formulaically, this is represented by the capital asset pricing model (or CAPM).
The capital asset pricing model states that the cost of equity (finance lingo for the required rate of return on stocks) is equal to the risk-free return rate plus the equity risk premium:
Ri (Cost of Equity) = Rf (Risk-Free Rate) + ERP (Equity Risk Premium)
Here’s where the 10-year Treasury yield steps in.
How the 10-Year Treasury Yield Affects Stocks
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.
Ri = 10Yr Yield + ERP
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.
Of course, this dynamic has a more severe impact on growth stocks than value stocks. That’s because value stocks have less value riding on future cash flows than growth stocks, and therefore, their present valuations are mathematically less impacted.
This is why hypergrowth stocks are plunging right now, while value stocks are going through a milder correction.
Now… let me tell you why this is all so overblown.
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.
Equally as powerful is globalization, as the global geopolitical stage is now set for globalization to come back into the spotlight and for companies to more aggressively outsource labor and production, which will keep consumer prices low.
Long-term, then, we are stuck in a lower-for-longer situation when it comes to interest rates.
The Best Stocks to Buy on This Dip
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.
My numerical analysis of the relationship between interest rates and equity valuations dating back to the 1980s 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.
Thus, with yields at 2.5% in late 2021, history says that an appropriate trailing earnings yield in the stock market is about 3.5%. That equates to a trailing earnings multiple of about 28X.
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.
That’s especially true for hypergrowth stocks, since their decline has been more pronounced and many of them are now significantly undervalued – even after accounting for higher rates.
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.
Now, if you’re looking for a great stock to buy, my favorite stock pick is one I believe could turn into the next Amazon. Click here to watch my first-ever Exponential Growth Summit to find out the name, ticker symbol, and key business details of this potential 10X stock pick.
On the date of publication, Luke Lango did not have (either directly or indirectly) any positions in the securities mentioned in this article.
By uncovering early investments in hypergrowth industries, Luke Lango puts you on the ground-floor of world-changing megatrends. It’s how his Daily 10X Report has averaged up to a ridiculous 100% return across all recommendations since launching last May. Click here to see how he does it.