What Rising Interest Rates Really Mean For Your Stocks In 2022 And Beyond

seekingalpha2022-03-19

Samuel Corum/Getty Images News At the Fed, we are strongly committed to achieve maximum employment and price stability. Today, in support of these goals, the FOMC raised its policy interest rate by ...

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Comment（7）

Roykhor77
·2022-03-21
Nice
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wallence82
·2022-03-20
2022 is the year for cloudflare
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Tantiad
·2022-03-20
[Miser]
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RIC
·2022-03-19
great news
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Tanyl
·2022-03-19
Good explanation for new investor
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N00b
·2022-03-19
Thanks for sharing
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NPC69
·2022-03-19
K
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Today, in support of these goals, the FOMC raised its policy interest rate by 0.25%. The economy is very strong and against the backdrop of an extremely tight labor market and high inflation, the committee anticipates that ongoing increase in the target range will be appropriate.\n\n With this statement on March 16, Fed Chairman Jerome Powell finally announced the long-awaited start of a new interest rate hike cycle. The near-zero interest rates will be lifted dramatically in 2022 and beyond. FOMC members are anticipating a Fed funds rate of 1.9% by the end of 2022 and 2.8% a year later. Importantly, Powell indicated that the Fed will be even more aggressive with rate hikes if necessary. Without a doubt, interest rates have been the most-discussed topic over the past months. The first word that comes to investors' minds when hearing about significantly rising interest rates is \"recession\". Should you really expect this to occur and how would this affect you? Many analysts have attributed the recent crash in growth stocks and outperformance of value stocks to rising rates. Is this correct? If so, should you expect further pain to come during the upcoming hike cycle? There are a lot of questions to be answered regarding interest rates. I'm here to answer them for you in a well-structured, non-biased article. I will start off by providing a theoretical background about interest rates. After that, I will provide insightful data on how this theory has translated to historical stock market returns. To end, I will discuss how you should approach the upcoming rate hike in 2022 and beyond. The Theoretical Effect Of Rising Interest Rates Rising interest rates are perceived as negative for investors, but why? Let me explain so in this section. The most important impact of rising rates can be divided into two categories:  The macro-economic impact The valuation impact  1. The macro-economic impact of interest rates Rising interest rates affect the investment of millions of businesses and consumers. Taking on a loan to fund a new investment becomes less attractive when interest rates rise. As such, central banks across the world can use interest rates as a tool to get the economy to a steady equilibrium. If the economy gets overheated, central banks can increase their rates to slow down economic activity. If the economy weakens, central banks can decrease their rates to improve economic activity. The central bank of the USA, the Fed, uses interest rates as the primary tool to reach its two economic goals: Price stability (2% annual inflation) and maximum sustainable employment (unemployment rate of 4.1%). In 2020, the pandemic led to a jump of unemployment rates to as much as 14.7% and an annual GDP decline of 2.2%. The Fed brought down interest rates to near-zero to improve economic conditions. It worked: Unemployment declined to 3.8% and GDP rose by 10.0% in 2021. However, there was one problem: The excessive monetary stimuli led to inflation rising well above the Fed's target (7.9% vs 2%). As such, it is the Fed's job now to slow down economic activity by rising interest rates. Rising interest rates will likely decrease macro-economic activity, which impacts the growth perspectives of companies. As you can see in the chart below, interest rate hike cycles have historically been followed by a recession (grey) most of the time. Federal funds rate and recessions over time (FRED)  2. The valuation impact Second, interest rates have a significant impact on stock market valuations. This is the most technical part, so I will spend more words on it to make you understand. By buying shares of a publicly listed company, you have a theoretical ownership on the cash flows that the company will generate in the future years. It can be compared by the rent you receive when you buy and rent out a real estate property. To calculate what that company (or property) is worth today, you have to take the sum of all future cash flows (or rents). However, you need to discount these cash flows (rent) based on the time value of money and risks regarding the company (property). This valuation method that discounts future cash flows at a certain rate is called a Discounted Cash Flow (\"DCF\") model. Let me explain it further. Discount rate formula, excluding \"cost of debt\" (Insider Opportunities)  Imagine you won the lottery and you can choose from two pay-outs: Receiving $1 mln now or $1.5 mln in 2032. Determining the best choice will largely depend on the (inflation-adjusted) risk-free interest rates at that moment. Today, you would be able to invest that $1 mln in risk-free 10-year US government bonds which are yielding 2.2% per year. As it is extremely unlikely that the US would default on its debt, you are guaranteed that your $1 mln will grow into $1.24 mln (1.022^10) by 2032. For risk-averse people, choosing the $1.5 mln option would clearly be the best thing to do given the low risk-free rate they can generate on the $1 mln. In contrast, imagine that 10-year government rates would yield 5%, like in the early 2000s. In this case, your $1 mln could grow into $1.63 mln (1.05^10) without taking risks. The time value of money makes the \"1 million today\" option superior. Insider Opportunities You could also look at it the other way around: Is today's discounted value of the $1.5 mln in 2032 higher than the $1 mln or not? In example 1, the discounted value is $1.15 mln ($1.5 mln*(1-0.022)^12), so you choose for the $1.5 mln option in 2032. In example 2, it is $0.81 mln ($1.5 mln*(1-0.05)^12), so you choose for the $1 mln option today. A rise of the Fed funds rates from 2.2% to 5% changes your view on the two lottery options as money in the future becomes less attractive. Similarly, changes in the time value of money also have a theoretical impact on the value of stocks according to the DCF method. For completeness, let me also explain the risk factor of the DCF model. We do not only want to be rewarded by the risk-free rate when we invest in stocks, we want an extra return for the risks related to this investment (bankruptcy risks, market volatility risks, etc.). Otherwise, we would all invest in much safer bonds. In general, we demand an extra return of 8% annually for these risks, the historical average annual return for the S&P 500 Index. However, stocks with higher volatility (calculated by the beta) require a higher risk factor. Note that this risk factor remains constant regardless of interest rates. So, now that I explained to you the theory behind discounted cash flows, let's start with the fun part: Calculating the theoretical impact of rising interest rates on the valuation of stocks. I will make the calculations for three types of companies: Value, growth and high-growth. Value stock Imagine a company which is not reporting any growth because it is operating in a stagnating market. Some examples include Verizon (VZ), Walmart (WMT), Johnson & Johnson (JNJ), Cisco Systems (CSCO), etc. At today's 3-month T-bill rate (0.46%), this company's cash flows should be discounted at 8.46% (0.46% + 1*8%), assuming a beta of 1. However, if the Fed sticks to its plan of raising rates to 2.8% next year, the discount rate would grow to 10.8% (2.8% + 1*8%). If inflation continues getting out of hand, interest rates might potentially even be raised to 5%. This would increase the discount rate to 13%. In the chart below, you can observe how these different rates (grey=8.46%, blue=10.8% and yellow=13%) affect the discounted value of the no-growth company's future cash flows (dark blue). As you can observe, the cash flows in the near future are barely affected by higher rates. However, as we go further in the future, a higher discount rate strongly affects today's value of cash flows. In fact, the discounted value of $100 of cash flows in year 20 is worth over double the amount at an 8.46% discount rate compared to a 13% rate. Insider Opportunities At a discount rate of 8.46%, the fair value of this company (a sum of all discounted cash flows) is $1,112.1. In other words, a fair price/free cash flow multiple today would be 11.1x. This stock is oftentimes called a \"value stock\" because it is trading at a low multiple. However, if the discount rate would increase to 10.8%, the fair value would shrink by 23.6% to $849.4. If we raise the discount rate to 13%, the fair value would shrink by 38.2% to $687.0. In other words, an increase of the federal funds rate to the 2.8% target would theoretically decrease the fair value of value stocks by 23.6%. An extreme 5% interest rate would lead 38.2% lower valuation. Growth stock Now, imagine a company which is growing at 8% consistently over time (and 3% in perpetuity). This is the average EPS growth rate of the S&P 500 (SPY) in the past thirty years. Companies with similar growth rates include Apple (AAPL), Microsoft (MSFT), Costco (COST), etc. If you understand the theory laid out above, you can already see this one coming... These stocks get much more affected by interest rate hikes because their valuation is mostly based on cash flows in the distant future. Insider Opportunities At a discount rate of 8.46%, the fair value of this company is $2,334.5. In other words, a fair price/free cash flow multiple today would be 23.3x. However, if the discount rate would increase to 10.8%, the fair value would shrink by 34.5% to $1,529.2. If we raise the discount rate to 13%, the fair value would shrink by 51.5% to $1131.5. An increase of the federal funds rate to the 2.8% target would decrease the fair value of growth stocks by 34.5%. An extreme 5% interest rate would lead 51.5% lower valuation. High-growth stock Lastly, imagine a high-growth company which can grow by 40% in the first five years, 20% in the following five years and 10% in the following ten years (3% perpetuity rate). Some examples of such stocks include Nvidia (NVDA), Tesla (TSLA) and Palantir (PLTR). These stocks are obviously affected the most by interest rate hikes. Insider Opportunities At a discount rate of 8.46%, the fair value of this company is $15,051. In other words, a fair price/free cash flow multiple today would be 150x. However, if the discount rate would increase to 10.8%, the fair value would shrink by 42.8% to $8,617. If we raise the discount rate to 13%, the fair value would shrink by 62.8% to $5,603. An increase of the federal funds rate to the 2.8% target would decrease the fair value of high-growth stocks by 42.8%. An extreme 5% interest rate would lead to a 62.8% lower valuation. In short, the theoretical DCF valuation method implies that all stocks would suffer drastically from interest rate hikes. However, the impact on high-growth stocks would be almost double as bad as on value stocks.     Fed Funds Rate to 2.8% Fed Funds Rate to 5%   Impact valuation value stock -23.6% -38.2%   Impact valuation growth stock -34.5% -51.5%   Impact valuation high-growth stock -42.8% -62.8%   The Impact Of Interest Rates On Stock Prices Fortunately, the stock market does not move based on just one theoretical model. There are many other factors to consider in addition to the impact on higher rates on the DCF model. A very interesting table has become viral in the investment industry over the past months. History proves us that during historical interest rates hike cycles, the S&P 500 has actually generated a very strong 8.6% annualized return. Ken Fisher Twitter Isn't this the exact opposite of what the theoretical framework discussed in this article assumes? Yes, it is. Is this a reason for you to become bullish, now that a new rate hike cycle is announced? Not per se. Let me explain. First of all, markets are forward-looking mechanisms. Markets are always pricing in the likelihood of something occurring in the future. Recently, the markets topped in December 2021 as the Fed was already hinting about an upcoming rate hike cycle. Such corrections which are occurring in anticipation of rate hikes are not included in this table's data. Second, there are always many factors to take into account in the stock market. In this case, the correlation between interest rate hikes and economic strength is very important to consider. Rate hikes only occur when the economy is in a very strong spot. Yes, interest rate hikes decrease the discounted value of future cash flows. However, growing expectations about future cash flows can more than offset this. There is a correlation between rising interest rates and strong market returns, but not a causation. A strong economy causes both rate hikes and strong market returns. Insider Opportunities with Canva The other way around, the end of an interest rate hike might be followed by very weak market returns. However, don't you think this might be caused by the fact that the Fed only stops raising interest rates when a recession might be looming? A recession can ultimately hurt stocks much more than the theoretical valuation increase due to lower interest rates. Given the two above-mentioned factors, I believe the viral interest-rate-hike-table is clueless. In contrast, the following chart might provide you with a much better understanding of the correlation between interest rate cycles and market returns. The chart plots the Fed funds rate (blue) against the 2-year forward return of the S&P 500 (green/red). As you can observe, the beginning of a rate hike cycle is oftentimes followed by very strong two-year returns. This could be caused by the fact that early rate hike cycles are oftentimes correlated with a strongly recovering economy. This was not the case in the 70s. Why? Because then interest rates were hiked with the primary reason to lower red-hot inflation, instead of a strong economy. When should you become worried about interest rates? When we are approaching the end of a rate hike cycle. When rates are raised too much, an economic recession is looming, which hurts earnings and thus also the stock market. Insider Opportunities What about the theory that value stocks should outperform during rate hike cycles? Again, we see a much more distorted chart here than you would expect. The chart below plots the Fed funds rate (blue) against the 2-year forward return of the Wilshire Growth Index minus the Wilshire Value Index. Again, I believe the two above-mentioned factors lead to a different outcome than one would expect. Growth stocks tend to actually do pretty well when interest rates are hiked (1987-1989, 1992-1995, 2015-2019) as they generally benefit much more from a strong economy than value stocks. Also, markets are always forward-looking. Strong growth vs value returns tends to occur not together with lower interest rates but in anticipation of them. Insider Opportunities with FRED data This Is Much More Important Than Interest Rates You have to understand the importance of investor sentiment in the market. Sentiment is a much stronger driver for returns compared to news, especially in the short-to-mid term. Investors who learn to take advantage of sentiment will be able to accumulate their wealth at much higher returns. Markets become overbought when investors get too greedy and oversold when they become too fearful. By making your portfolio more defensive when markets are greedy and aggressive when they are fearful, you can generate much stronger returns. At Insider Opportunities, we follow up market sentiment for our members on a daily basis via our \"IO Opportunities & Risks Index\". As this index pointed to extreme greediness in early 2021, we were able to avoid the crash in high-risk assets over the past months. As explained in my recent article \"Bottom Predictor Urges You To Buy The Current Dip\", we urged investors to become more aggressive on the opening at March 9. Sentiment became extremely fearful according to our index. On March 9, terrible news was spread into the world as Russia started invading Ukraine. On March 16, the Fed announced that we should expect much higher interest rates in the coming years. One would expect the markets to plunge on both days. Guess what, the opposite happened. The Nasdaq Composite (QQQ) rallied by over 3.5%, indicated by the yellow ellipses on the chart below. Why did the unexpected occur? Sentiment was already extremely fearful with QQQ in the bear market territory and many stocks down by over 50% from their recent highs. It is your job to not get distracted by the news flow but continue to focus on what really matters: Sentiment. TradingView Market sentiment should impact your portfolio positioning. In addition to that, it should also impact your individual stock-picking decisions. As discussed in my most recent article \"The Untold Truth Of Why Stocks Crashed This Earnings Season\", individual stocks also move in overbought and oversold cycles. This is mainly based on sentiment regarding short-term earnings reports. When Zoom (ZM) reported revenue growth of 369% at the beginning of 2021, investors bid it up to a ridiculous 120x EV/sales valuation. Now, one year later, investors don't want to touch the stock at 7x EV/sales as the revenue growth outlook is falling to single digits. Did anything change fundamentally with Zoom? No. Were investors way too greedy on the way up and are they becoming way too fearful on the way down? Yes. Take advantage of fear & greed for individual stock picking as well. Find companies with great long-term fundamentals which are unjustifiably sold off by the market in the short term and you will do well. Insider Opportunities Easier said than done in such an uncertain market environment as today, right? Well, that's why our members find so much value in our unique insider strategy. Insiders are the CEOs, CFOs, Board Members, Vice Presidents... of a company. They can buy shares of their own company when they believe the market is significantly undervaluing it. We can follow up on these purchases as they are made public by the SEC. If there is one investor who can accurately know when fear in the market is unjustified, it is the insider. He/she knows how the company will perform in the future. Following this smart money can provide you a lot of confidence that strong returns will follow in the future. Of course, this should be contextualized as well. Not all insider information is as accurate. That's why at Insider Opportunities, we adopt proven algorithms and perform thorough due diligence to find the winning stocks amongst hundreds of insider purchases each month. Investor Takeaway For 2022 And Beyond Rising interest rates impact future economic growth rates and theoretically lower the valuations of stocks. However, history proves to us that it is important to contextualize this in the broader market framework. We do believe a recession will likely occur in the coming two years for several reasons:  We will face very tough economic comparisons due to the excessive money printing by the Fed which artificially pumped up economic growth rates over the past quarters. The Fed will need to raise interest rates drastically to combat inflation, which will impact corporate and consumer spending. Consumer spending is further impacted by skyrocketing energy prices, which have historically caused many recessions. The 10-2 year yield spread is contracting heavily and approaching the negative territory. This has been an extremely accurate recession predictor in the past.  As such, we continue to urge you to avoid the following investments:  Highly cyclical companies which will be strongly affected by a recession, such as homebuilders, retailers and car manufacturers. Avoid stocks like Ford (F), Toll Brothers (TOL) and Macy's (M) at all cost. Companies with a weak balance sheet and negative free cash flow generation. They might go bankrupt if liquidity in the market dries up. Avoid stocks like fuboTV (FUBO), Carvana (CVNA) and SmileDirectClub (SDC) at all cost. Growth companies which are still trading at extreme valuation multiples despite their recent downturn. They face more downward pressure as the Fed turns hawkish. Avoid stocks like Snowflake (SNOW), Cloudflare (NET) and Zscaler (ZS) until valuations become more attractive.  We do want to underscore, however, that a recession is not the end of the world. The recessions which come to our mind first are the ones in 2020, 2007-2008 and 2000-2001, which led to steep losses in the stock market. However, what many investors fail to remember is that the three recessions prior to those were \"soft recessions\". In 1980, 1981-1982 and 1990-1991, the stock market was not affected that heavily and recovered quickly. As businesses and consumers are healthier than ever, we believe this will be the most likely outcome for the next years. We are adjusting our portfolio positioning from defensive to aggressive in this market environment. Why? Sentiment reached \"extreme fear\" levels last week, which creates fantastic buying opportunities even when the future looks somewhat cloudy. We are especially bullish regarding two assets:   Growth stocks that got unjustifiably punished by weak market sentiment and are cheaply valued compared to their strong prospects. Axon Enterprise (AXON) is one of the several stocks added to our portfolio at Insider Opportunities recently. Axon's Director Partovi added $10 mln shares on this unjustified dip. Axon is currently valued at 8x EV/sales, which is attractive given its 63% gross margin and 27.5% growth rate.  High-quality value stocks which are attractively valued and can easily withstand an inflationary/recessionary period. For example, we continue to be very bullish on Vertex Pharmaceuticals (VRTX) which has a monopoly in its market and is printing billions of cash flows each month. Its CEO and Director purchased $2 mln and $3 mln shares last year.  We are looking forward to continue accumulating our wealth in the market through our proven strategy. I hope you got a better understanding of how markets work by reading this article. Don't get distracted by the news and keep your focus on what really matters: Company fundamentals and market sentiment.","kind":"news","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[{"id":9034188226,"gmtCreate":1647825888129,"gmtModify":1676534269259,"author":{"id":"3577415925422402","authorId":"3577415925422402","name":"Roykhor77","avatar":"https://static.tigerbbs.com/dceebb2c02d2b0c1df8a4c7c7ebba8d9","vip":1,"crmLevel":1,"crmLevelSwitch":0,"idStr":"3577415925422402","authorIdStr":"3577415925422402"},"htmlText":"&nbsp;Nice","listText":"&nbsp;Nice","text":"Nice","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":3,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9034188226","repostId":2220092717,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9034987434,"gmtCreate":1647757351706,"gmtModify":1676534263795,"author":{"id":"3564307944903490","authorId":"3564307944903490","name":"wallence82","avatar":"https://static.tigerbbs.com/dea005ab03386f13fa25c505b9a3221a","vip":1,"crmLevel":7,"crmLevelSwitch":0,"idStr":"3564307944903490","authorIdStr":"3564307944903490"},"htmlText":"2022 is the year for cloudflare","listText":"2022 is the year for cloudflare","text":"2022 is the year for 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news","listText":"great news","text":"great news","images":[],"top":1,"highlighted":1,"essential":1,"paper":1,"likeSize":3,"commentSize":0,"repostSize":0,"link":"https://ttm.financial/post/9035779924","repostId":2220092717,"repostType":2,"isVote":1,"likeStatus":false,"favoriteStatus":false,"reportStatus":false,"tweetType":1,"langContent":"EN"},{"id":9035743524,"gmtCreate":1647702981909,"gmtModify":1676534259477,"author":{"id":"4087109808120260","authorId":"4087109808120260","name":"Tanyl","avatar":"https://static.tigerbbs.com/174329973340cf0f5b68791ee5b08afd","vip":1,"crmLevel":9,"crmLevelSwitch":1,"idStr":"4087109808120260","authorIdStr":"4087109808120260"},"htmlText":"Good explanation for new investor","listText":"Good explanation for new investor","text":"Good explanation for new 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