Why High Interest Rates Are Bad for Stocks
A couple of notes before the actual substance--thank you for refraining from
chuckling--of today's column: Today's stock-market action was actually quite
fascinating to watch, especially once the early-day plunge was out of the way.
Unlike yesterday, when stocks fell in unison, there was a meaningful divergence
between stocks today. The most obvious example of this was the contrast between
the Dow's rise and the Nasdaq's fall, but the more interesting example was that
by the end of the day most (though, not all) of the tech powerhouses--that is,
those with profits--had recovered sharply and were actually up on the day,
while most (though again, not all) of the Internet high-fliers, in both the
e-retailer and B2B camps, were down, often sharply. As I suggested on Monday,
this kind of divergence is a good and comforting thing, since it suggests
investors are distinguishing between companies rather than throwing them all
into one big buy-or-sell pot.
The other good--and comforting--thing was that both the New York
Times and the Washington Post led with Greenspan's reappointment
rather than with the market sell-off. (I realize I wrote about the
sell-off yesterday instead of Greenspan, which might seem to be
discomfiting by my standards, but I've already issued too many hosannas to the
Great Alan for another one to be interesting. Until the next one, of course.)
For that matter, the Daily News put the Turner-Fonda separation on its
front page. These seemed like nicely measured, and somewhat surprising,
reactions to what might have been played as a much scarier event than it really
was.
One crucial ingredient in all of today's explanations of the sell-off (and
we are now entering the putatively substantive part of the column, so watch
your heads) was, of course, "interest-rate concerns." Unfortunately, it's
usually not explained why people who are investing in stocks should be all that
concerned about interest rates. In fact, they should be--and are--concerned.
It's just that the reasons for their concern are complicated, because interest
rates affect stocks in different ways and, for that matter, because there are
different interest rates to be concerned about.
The interest rate that most journalists have in mind when they talk about
"interest-rate concerns" is not the interest rate that you see at the bottom of
that bug in the corner of the CNBC screen. That's the interest rate on the
30-year U.S. bond. The rate most journalists are talking about is the federal
funds rate, which is the interest rate the Federal Reserve raises or lowers in
order, in theory, to speed up or slow down the economy by increasing or
shrinking the size of the U.S. money supply and indirectly raising or lowering
interest rates on things like car and home loans (since banks pass along
changes in interest rates to their customers). It now appears that the Fed will
raise interest rates at its February meeting, and of late investors have got it
in their heads that instead of its typical 25-basis-point (0.25 percentage
point) increase, the Fed is going to hike rates by 50 basis points.
These interest-rate concerns, then, are concerns that the Fed's actions will
slow down the economy, which in turn will make corporate profits grow less
quickly than otherwise, and since investors are paying prices for stocks that
assume very fast profit growth in the future, the threat of a slowing economy
makes them want to sell.
Fair enough. But one of the odd things about this most recent sell-off is
that, with the exception of banks (which are always hit hard by interest-rate
worries), the hardest-hit companies were those companies whose profit prospects
will be the least hurt by a fed-funds hike. If you're a big retailer, or an
aluminum company, or even a car company, an interest-rate hike could
have--though I stress could--a big impact on your business. But if you're Cisco
(which I own) or another major supplier of technological infrastructure to big
business, you're going to weather anything short of a complete recession,
because American business shows absolutely no sign of cutting back on
investment. And that's because in this competitive environment, it can't.
So why would interest-rate concerns hit the high-priced tech stocks so hard?
You might ascribe it simply to panic, which undoubtedly played a part. But
there are also two other reasons, which have to do with that other interest
rate, the one on the 30-year bond. That interest rate is effectively the
risk-free rate of return for any investment you want to make, and as the
interest rate on bonds rises, bonds become more attractive and stocks less
attractive. This has a practical consequence, which is that rising rates lead
institutions--primarily, at this point--to pull money out of the stock market
and put it into bonds. And the opposite is true when rates are going in the
other direction.
But rising rates also have a theoretical consequence that's even more
important. If you want to figure the present value of a stock--which is to say,
how much it's worth today given how much free cash flow the company is going to
generate in the future--you need to discount that cash flow by your required
annual rate of return. (If your required rate of return is 10 percent, then the
total free cash generated by the company in 20 years needs to be divided by 1.1
to the 20th power.) And a crucial component of that rate of return is the
interest rate on the 30-year bond, since you know you can get that without any
risk at all.
If interest rates rise, then, the present value of the future cash generated
by the company--even if the amount of that cash is unchanged by the rise in
interest rates--shrinks. Even a relatively small rise in interest rates can
have a major effect on that present value if it's spread out over 30 years. And
since the stock prices of the most valuable companies in the world today in
fact reflect investors' confidence that they're still going to be generating
huge amounts of cash 30 years from now, rising interest rates can have serious
effects on current stock prices.
In the end--although you'll hear plenty of people tell you that this is an
old-fashioned idea--a stock's price is a mechanism for discounting the future.
And as the discount rate rises, it's not surprising if stock prices fall. The
equation is not automatic or perfect. But in the long run, it's
unavoidable.
