By Jon Sindreu
March 21, 2022
This is the second column in a Heard on the Street series about the end of zero interest rates.
There is a new urgency to the old question of how much credit falling interest rates should get for your stock portfolio’s strong performance.
The Federal Reserve and Bank of England have raised borrowing costs over the past week, confirming the end of near-zero rates and, analysts fear, of a decadeslong boost to stock valuations.
Higher share prices relative to company earnings explain half the returns of the S&P 500 over 10 years. That proportion rises to 60% for the technology-heavy Nasdaq as Google parent Alphabet Inc., Meta Platforms Inc. and Amazon.com have left “old economy” banks and utilities in the dust.
The raft of profitless tech-focused startups that hit the market last year, such as electric-vehicle maker Rivian Automotive Inc., fintech lender SoFi Technologies Inc. and various air-taxi ventures, seem particularly exposed to the turning tables. Otherwise, though, investors need to do some homework before simply rotating back to old-economy sectors.
A bond with a 2% coupon becomes less attractive when the return investors get by leaving the money in the bank rises from 0% to 1%. And its resale value will fall a lot more if it matures in 10 years rather than in two, because investors are locked in for a decade of disappointing returns. In financial jargon, it has higher “duration,” which is both a measure of sensitivity to rates and the weighted average time until all the cash flows are paid.
What about stocks? While they offer much more legroom to speculate because payments aren’t fixed, their value is—usually—still tied to expectations of making a profit. Mature businesses with predictable dividend payments can be seen as having low duration, whereas growth-led firms have more of their value tied to earnings in the distant future. Startups have extra-long duration: They are akin to buying a lottery ticket with a payout in 10 years’ time.
Most stocks, however, fall somewhere in between, which requires going beyond intuition or sector correlations with bond yields.
In a 2004 paper, University of Michigan researchers Patricia M. Dechow, Richard G. Sloan and Mark T. Soliman popularized a way to estimate a company’s “implied equity duration” by predicting future cash flows based on the growth of sales, earnings and book value. Applying their math to S&P 500, Euro Stoxx 50 and FTSE 100 stocks puts the duration of blue-chip stocks at around 20 years. As expected, the consumer services, healthcare and tech sectors, which have done better in the period of rock-bottom borrowing costs, rank above average, while energy, finance and telecommunications are below.
Sector averages are misleading, however. Within tech, the implied duration of Amazon and Netflix is above 23 years, whereas International Business Machines Corp. and Intel Corp. are closer to the market average and Hewlett-Packard Enterprise Co., a maker of laptops and printers, ranks near the bottom at less than 14 years.
Meanwhile, electric-vehicle maker Tesla Inc. is an example of a long-duration disrupter in a mature industry. Cable operator Charter Communications Inc. and clothing giants Inditex, Burberry and Under Armour Inc. are less-obvious cases of old-economy but high-duration stocks.
Investors need to be careful with distortions created by the pandemic, which sunk the short-term profits of some more traditional sectors. As a 2021 paper shows, the crisis lengthened their implied duration by tying more of their value to post-Covid earnings, making casinos and cruise companies look more growth-focused than they are.
Markets still predict that the Fed will keep rates below 3% this economic cycle, compared with more than 5% pre-2008. So this past decade’s trend may only be partially reversed, especially because much of the valuation premium fetched by the likes of Amazon and Alphabet reflects the growing dominance of these firms in the real world. Conversely, banks may make more money when rates are higher, but the main reason they have suffered in recent years is weak economic growth and stricter financial regulation.
This is the moment for investors to take a closer look at the duration of their individual stockholdings. But they shouldn’t forget that strong balance sheets and growing profits win the day, no matter where interest rates are.
Write to Jon Sindreu at email@example.com
Dow Jones & Company, Inc.