Why Are Stocks And Bonds Both Down? Part II:

Part II: Stocks:

In my last article, I looked at how changes in interest rates affect bond prices.

It might seem that stocks are very similar to bonds. After all, stocks pay dividends, and some investors consider stocks that pay regular dividends to be “bond-like.”

Stocks are more complex than bonds, however. Dividends represent the portion of earnings a company distributes. Retained earnings are the rest and add to the company’s value. Shareholder income in any year is the sum of dividends and retained earnings – the company’s total: earnings. A stock’s earnings differ from a bond’s coupon in several ways.

  • The company makes no (enforceable) promise about what earnings will be.
  • Earnings vary from quarter to quarter and from year to year.
  • Earnings are not known in advance.
  • Earnings continue indefinitely – a stock does not “mature.”

In another difference from bonds, stock owners receive a “principal” payment for the value of their position only when the company winds up its operations or when it is acquired.

Let’s look at cash flows for stocks in a couple of hypothetical companies, a “utility” and a “tech” stock. The “utility” has stable earnings, while the “tech” stock’s earnings rise and fall sharply and then level off. I’ve constructed this example so that both companies are worth $1,000 at a 10% interest rate. Even though the “tech” company has larger earnings starting in year 17, those larger earnings are brought to the present by a much smaller present value factor (the second chart omits factors for years 6 to 30 as the vertical black line suggests).

Suppose interest rates rise from 10% to 12%. Just as with bonds, if the cash flows don’t change, the stock prices will fall because the present value factors get smaller. The chart following the table illustrates that present value factors shrink more in the future. You might imagine that the tech stock’s price will suffer more, because its larger cash flows are further in the future, and you would be right. While the “utility” stock’s price drops 17%, the “tech” stock drops almost 37%!

Rising interest rates can affect stock prices in the same way they affect bond prices.

Furthermore, this illustration is broadly consistent with investment returns in the first half of the year, when the technology-heavy NASDAQ
NDAQ:
index declined more than the market-wide Russell 3000.

What Factors Influence Stock Prices?

Many factors beyond interest rates influence stock prices. Two summary measures of those factors are earnings forecasts and earnings growth rate forecasts. These forecasts summarize investors’ expectations about a company’s profitability prospects. Companies provide a wide range of products and services to business and consumer customers near and far. They purchase raw materials, intermediate products, and employee services in local, regional, national, and global markets. Changes in any aspect of their operations can change their prospects.

In the first half of the year, many companies experienced changes in earnings forecasts and growth rate forecasts. Here are just two examples.

META (Facebook) announced in February that Apple’s:
AAPL:
privacy enhancements for users would reduce Facebook’s annual revenue by $10B, and that Facebook lost users globally for the first time. (META is now announcing layoffs).

Spotify: experienced: earnings forecast declines (subscriber growth is expected to slow in 2022).

As you might imagine, lower earnings forecasts lead to lower stock prices, and lower earnings growth rates: also imply lower stock prices, with disproportionate impact on stocks with high forecast growth rates (like “tech” stocks).

In short, the way stock prices behave when interest rates rise depends on what else happens when interest rates rise. In a “standard” business cycle, interest rates rise because investment opportunities improve – earnings and earnings growth forecasts increase. Bond prices would: decline as interest rates rise, but stock prices might rise: if investors project that earnings will increase fast enough to offset the effect of higher interest rates.

The data we saw in the first article suggests that “standard” business cycles are far from the only way the world works – otherwise stock and bond returns would: be negatively correlated.

In the next article, we’ll look at why it makes sense to hold bonds even if they aren’t negatively correlated with stocks.

All written content is provided for information purposes only. Opinions expressed herein are solely those of Sensible Financial and Management, LLC, unless otherwise specifically cited. Material presented is believed to be from reliable sources, but no representations are made by our firm as to other parties’ informational accuracy or completeness.

Information provided is not investment advice, a recommendation regarding the purchase or sale of a security or the implementation of a strategy or set of strategies. There is no guarantee that any statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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