The recent sell-off in growth and tech stocks has been attributed to rising bond yields. Government bond yields all over the world have risen sharply in the last couple months. As examples, the yield of US 10-year treasury notes increased from 0.9% in January to 1.45% today, the yield of Japanese 10-year bonds increased from 0% to 0.14%, and the yield of United Kingdom 10-year bonds increased from 0.2% to 0.75%. In this article, I'll breakdown the intricate relationship between government bonds and equities to unpack why the stock market experiences increased selling pressure from rising bond yields.
Growth stocks are extra sensitive to bond yields
A common interpretation of bond yields is the expected rate of future inflation. Bond traders expect a higher return from bonds if they expect more inflation. As such, they lower their bids for bonds, causing bond prices to fall and bond yields to rise. The money paid by a bond at maturity is fixed. As such, when bond prices fall, bond yields increase.
The primary effect of increased inflation is the decrease in value of future dollars. Inflation causes an expansion in the total number of dollars in circulation and the value of a dollar is diluted when there are more dollars out there.
This brings us to growth stocks, which have valuations that are highly sensitive to inflation. This is because growth stocks earn most of their revenue in the future (hence the moniker "growth"). You can see this using simple discounted cash flow analyses.
Consider a typical value stock that earns $100,000 in free cash flow per year and expects to grow its cash flow by 5% per year for the next ten years. If we expect a rate of inflation at 12%, then the total value of the next 25 years of cash flows will be $1.096 million. If we expect a rate of inflation at 8%, then the total value of next 25 years of cash flows will be $1.586 million. That's a 44.7% higher valuation after dropping rate of inflation by one third.
Now consider a typical growth stock that earns $100,000 in free cash flow per year and expects to grow its cash flow by 20% per year for the first 5 years, then 15% for the next 5 years, then 10% for the next 5 years, then 5% for the next 5 years, and then 3% thereafter once it’s fully matured. If we expect a rate of inflation at 12%, then the total value of the next 25 years of cash flows will be $2.860 million. If we expect a rate of inflation at 8%, then the total value of the next 25 years of cash flows will be $4.628 million. That's a 61.8% higher valuation after dropping rate of inflation by one third. We see that as interest rates fall, growth stock valuations increase faster than value stock valuations. This works the other way around, where falling interest rates causes growth stock valuations to fall faster than value stock valuations.
(Credits to Lyn Alden article for these examples)
Put simply, growth stock valuations are more sensitive to changes in inflation than value stock valuations.
This is why the recent steep increase in bond yields caused serious contractions in growth stock valuations. Many of them fell by double digit percentages in a little under a month. For example, Palantir fell by almost 40% since its peak of $38.17 in early February.
Growth stocks are not the only casualties of rising bond yields. Large cap tech stocks like Amazon and Apple have also been hit hard. These companies are cash flow generation machines with a lower expected growth rate than many small to mid cap growth stocks. Why are they also a victim of rising bond yields?
One way to understand the effect of bond yields on large cap tech stocks is to consider their earnings yields. The earnings yield of a stock is simply the earnings generated by a company in the past year, relative to its market cap. To calculate earnings yield, we simply inverse the stock's P/E ratio.
Let's use Apple as an example. Apple's P/E ratio in the start of the year is 35, so its earnings yield is 1/35, or 2.85%. If Apple was a bond, its yield is 2.85%.
Apple's 2.85% yield is significantly higher than the 10-year treasury note's 1% yield at the start of the year. This reflects the premium an investor earns for taking on extra risk holding Apple over a US 10-year treasury note. The return of a 10-year treasury note is guaranteed by the US government. It's thus considered the risk-free rate. If the US government falls, you have much bigger problems to worry about than the yield on your bonds and equities.
We see that the market prices Apple's equity risk premium to be 1.85% (2.85% - 1% = 1.85%). What happens when the risk-free rate increases to 1.5%? All else being equal, Apple now needs to have a yield of 1.5% + 1.85% = 3.35%. If Apple is expected to yield 3.35%, then its P/E ratio should be 30. That's a 14.3% decline from its January P/E ratio of 35, which is an equivalent decline of 14.3% in its stock price.
This is why tech stocks are also non-trivial victims of rising bond yields.
Modern portfolio theory and rebalancing
Finally, a third reason why rising bond yields places downward pressure on stocks is the prevalence of passive investing in today's market. In fact, respected macro-commentator Mike Green estimates that passive funds have 40%-45% market share in the US with more than 90% of the flows into markets being passive. Passive investing funds commonly adhere to the principles of MPT. A criminally simple explanation of MPT is that risk-adjusted returns can be maximized when a portfolio is diversified with uncorrelated assets. The most common example of this is holding both stocks and bonds. Respected macro-commentator Mike Green estimates that passive funds have 40%-45% market share in the US with more than 90% of the flows into markets being passive. A large portion of these funds are based on MPT. For example, many large target-date retirement funds fueled by the 401K system are MPT-based.
Bond yields rise because bond prices are falling, and falling bond prices causes an MPT passive fund to be underweight bonds. This is made worse by a rising stock market (the S&P 500 increased by 4.8% from the start of the year to its peak in February). What happens when a fund deviates from its ideal asset allocation? It needs to rebalance. A fund that's underweight bonds and overweight equities will sell equities to buy bonds.
Falling bond prices and rising equity prices in the past few weeks probably caused many MPT passive funds to stray far enough from their ideal asset allocation that they needed to rebalance. Because MPT passive funds are so widespread (probably collectively holding trillions of dollars of wealth), when many of them need to rebalance, they can have a significant impact on the market.
The US 10-year treasury yield was at over 3% in 2018, and around 1.8% in the start of 2020. Will a steady stream of positive reopening news push up inflation expectations and increase the 10-year treasury yield to 2020 levels or even worse, 2018 levels? It's hard to say where yields be in the future, but we know for certain that the Federal Reserve is the last line of defense against uncontrollably rising bond yields. The Federal Reserve's Quantitative Easing program keeps long-term yields (like the 10-year yield) in check. In a nutshell, QE involves the Federal Reserve conjuring up bank reserves and buying long-dated securities, such as 10-year treasury notes, on the open market. This buying adds support to the price of these securities and lowers their yield.
The effect of QE is an increase in the Federal Reserve's balance sheet. You can see the balance sheet spike hard in February during the COVID market rout, fall slightly from its peak in June, and steadily rise starting in July with the Federal Reserve's "QE infinity" program out in full force.
The recent rise in long-dated treasury yields might force the Federal Reserve to step up its QE program, but its hard to say when they will do so. The Fed could be comfortable with rates back at pre-COVID 2020 levels and that's a whopping 22% increase from the current yield of 1.45%.
The bottom-line is, stay cautious of growth stocks in the near future, and wait for the Fed to step in and save the day.