Current Market Events - The Relationship between Interest Rates, Yields & Technology Companies

Educational series to enable investors navigate turbulent markets

Hi Everyone:

It was an interesting week for the markets. I had prepared a research report on a good international stock, but due to the market action, I suspect many people are probably not in the frame of mind to read the report, so we’ll get back to reports next week.

In this article, I would like to explain the phenomenon that occurred this week as I am aware that a number of new investors are trying to understand the current market dynamics. While we do not want to focus too much on macro-economics more than business fundamentals. it is important to be aware of the general market condition and understand how different assets work. The conversation around interest rates vs technology will continue for the rest of 2021. This is because if a company delivers superior results but the macro environment is against them, it doesn’t matter. I thought I would use some of my Economics background to share some highlights of what is happening in the market in a simplified manner.

Overview of Today’s Report:

1. Basics: The Competition between Stocks and Bonds

2. Different Business Cycles: It is now net

3. Divergence between Technology Growth and Value

4. 2020 vs 2021 Technology Markets: Implications going forward.

Basics:

First, I really want people to know that institutions (Pension funds, Banks, Wealth Management etc.) control about 70-80% of the stock market. Hence, their mindsets are very different from that of retail investors (especially millennials). They follow the historical books to guide their investment actions which affects the average investor. This is key to remember.

The entire financial markets where you can make money is made up of either stocks or fixed income (Government Bonds, Treasury bills). Both assets are always in competition where ever the money flows.

Competition Between Asset Vehicles:

The competition is about determining the best places for institutions to manage risks and still make extensive returns.

1) Stocks are generally very risky but provide the best outsized returns (including some paying dividend yields). They are generally broken into:

• Technology and Growth stocks give you the best returns, but they are usually not profitable companies and most of their cash flows are discounted into the future.

• Value and Dividend stocks are much more mature businesses that are stable, profitable and generate current cash flows today.

2) Government Bonds are safe and secure assets, but provide the least returns.

• When you buy a long-term government bond, you receive a yield - defined as the expected returns from the bond annually. There is an inverse relationship (When people buy Gov’t bonds, the yield goes down; When people sell Gov’t bonds, the yield goes up to attract people). There are 2, 10 and 30-yr government bonds.

• 10-year treasury yields is the standard proxy for the risk-free asset that investors and analysts often use when talking about interest rate yields.

• Interest rates determine the $ yield return you receive from a Bond. The US Federal Reserve controls where Interest rates move. This video does a simple explanation of the movement: Video or this one for a full yield explanation since I’m using simplified language here.

Both assets are always in competition. If people are scared about a recession and worried as we observed in March 2020, they buy “safe” Government Bonds (Leading Yields down). And vice-versa, if individuals feel the economy will get better and recover, they feel comfortable investing in risky stocks <mostly value> and sell Bonds (Leading Yields Up) as illustrated below.

Business Cycles:

Let’s now consider the traditional overview of business market cycles and how they affect a number of sectors in the markets to provide some history. I won’t go over everything, I’ll just show the pertinent aspects, so you are not surprised by what is happening with technology stocks.

1) Recession Phase: I’ll begin with the red part which is in recession, similar to March 2020 - economic activity and corporate profits are declining, the stock market crashes, Government Treasury Bonds demand goes up (yields down) and the US Dollar goes higher. This is similar to previous crashes since there is a significant amount of fear and run for safety away from stocks and into Government bonds. In this environment, the stocks that perform well are Utilities, Healthcare, Consumer Staples (like Walmart) since people need these essentials to survive no matter what happens. Chart shows below.

Charts by All Star Charts

2) Post-Recession (Early in 2020): It was unique last year compared to previous recessions because most of the economic activities were happening “online” rather than a complete recession. Most company earnings and profits were accelerating for digital companies. As a result, investors figured out that tech companies are relatively safe havens, so we experienced the rise in the assets for digital and innovative company stocks (plus Govt bond yields were low because of demand & lower interest rates).

3) Recovery/Early Business Cycle Phase: The next phase of the cycle is recovery. This started happening after the vaccines were announced towards the end of 2020. Investors assumed that since we had a Covid19 solution plus the enormous amount of Government stimulus, we will be rapidly recovering from a recession. The expectation was that corporate earnings will begin growing and consumer spending will pick-up. During this stage over “history”, institutional investors switch to Consumer cyclicals (Like Energy, Industrials, Consumer Discretionary stocks) and Financials are owned. Interest rate yields begin to rise like today due to the anticipation that things are going to get better. Investors sell bonds (yields go up). This development reduces technology stocks with high-valuations since there is growth in the economy. Analysis is based on historical data, so we should not be surprised this is happening today.

4) Mid-Late Business Phase: This is typically the longest phase of the business cycle. The economy is stronger, but growth is moderating. Over these long-term periods, the best stocks that perform with relatively low rates are the technology stocks that are growing rapidly. Included are industrials and basic materials.

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Why Technology Outperformed In 2020:

During the panicky phase of 2020, the yield return on a Gov’t bonds were down as shown below. This created a situation known as Negative real yields (Low Bonds after substracting Inflation), allowing institutions to pay up and buy highly valued technology and innovative stocks, thus leading to a wide gap in valuations as seen below. Currently, in early 2021, the average return you could get from a 10-year bond yield is equivalent to the return of an average stock on the markets (S&P 500). Once this conflict occurs, there will always be a challenge and that’s what happened over the last couple of weeks since institutions can reduce their exposure to stocks and put some money into yields.

Due to high levels of optimism and high valuations in 2020 - there has been a huge divergence between technology and traditional value stocks due to digitization over the last decade - unbelievable performance for the technology sector.

Today 2021

• The Government bond yield returns are rising from their pandemic lows which means people are optimistic about the future and no longer want to hold on to Gov’t bonds (compared to March 2020). Normally, this should be good for the overall market, but due to the speed of movement of yields, there is short-term volatility. Meaning, the cost of owning the over-valued technology stocks are much higher relative to the return you get from Gov’t bonds compared to what we had in 2020.

As the 10-year Treasury yield has climbed higher over the past month, the cost of equity (ownership of mostly tech stocks) has theoretically risen too due to Bonds showing their power.

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. Of course, this dynamic has a more severe impact on growth stocks than value stocks.

Historically, higher interest rate yields are beneficial for boosting the earnings of financial institutions because they make more money from lending as well as industrial stocks. Below is another chart demonstrating the divergence from growth technology stocks and into value recently over the last few weeks.

Implications & Going Forward

• Based off historical data, we are in the early stage of a business cycle/Bull Market. The stock market will do great over the next couple of years. Value and Growth need to come together to make it happen. Technology and innovation stocks will do okay in 2021 - but because the economy is recovering, value stocks will outperform them. However, long-term, innovation wins!

• Mean reversion means the rotation will continue - money will be flowing out from Software Technology into Cyclical Technology stocks like Semi-conductors, International stocks, Financials, Industrials, and Energy, but not everything will come out because we are experiencing a massive digital transformation in technology.

• Focus on researching and finding the very best technology stocks that will perform well in this environment i.e. only companies that have strong fundamentals. Don’t buy from companies based on “Hope for the future.” The market will scrutinize against stocks that do not have sound fundamentals and you’ve seen it. At Investi Analyst, this is our goal.

• Last evidence that this is a bull market is because Historical Risky Assets linked closely to the re-opening of the economy/early business cycles are performing well today compared to March 2020; Emerging Markets, Copper, Small Caps, Financials, Dow Transport, Consumer discretionary and Corporate Junk bonds etc are outperforming. This is a bullish signal. Overall the market is doing great.

Bottom-Line:

My plan is to explain to my subscribers the data and information to help you understand market dynamics and make an informed decision. Everyone has different goals, risk appetites and investment horizons. Rates may be rising now off their lows, but they'll stop rising soon, and settle down at levels much below their historically average levels. Tech will normalize again, maybe not to the extent that we saw in 2020. If you are a long-term investor who doesn’t need your money anytime soon in 2021, be very patient. I expect tech outperformance by late 2021/into 2022. If your preference is for value stocks, pick wisely as well and you will do well.

Always remember, investing is for the long-term. The faster you want to make money, the faster you’ll lose it and vice-versa. I will encourage a bit of diversification of a portfolio but everyone has different methodology to approaching markets and what they want in a portfolio. Next week, we will get back to company reports and start identifying good brands to consider investing in.

Thanks for reading and have a good weekend.

Your Thoughts: What do you think about the markets?

Most Sources from Bloomberg, AllStar Charts and Investor Place

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