“The 10-year Treasury versus the stock market: Who wins?” This is a $1-trillion question that the stock market has been debating over the past few weeks. $1 trillion is about how much big tech stocks lost in market value in recent weeks, as the benchmark 10-year Treasury yield soared above 3%, a level not seen since 2018. But to fully understand why rising bond yields make stocks less attractive, we need to look at what those yields mean in the real world and why they move.

Why should we care about bond yields

Bond yields, which move inversely to bond prices, have been going up attributably to fears of high inflation, or more specifically, the decrease in purchasing power of cash. Consumer prices in April came in this week around 40-year highs. Traders/ investors are relentlessly selling bonds — again, prices fall, yields rise — on worries that the Federal Reserve’s gradual approach to raising short-term interest rates will slow the economy, yet ineffective against inflation.

On Main Street (for a normal person, a business, a corporation), many types of loans are benchmarked against the 10-year treasury yield and/or the Fed’s policy interest rates. So when yields and rates go up, interest rates on loans go up. Higher cost to borrow money will reduce economic activities (for example, because the interest rate to borrow money to buy a house is higher, less people will be able to afford to buy houses).

On Wall Street, here's where stocks get a double whammy. One, inflation in general takes a bite out of a company's earnings (because of higher input costs). Two, higher borrowing costs also hurts, especially companies that have a lot of debt. So-called non-profitable growth stocks, particularly ones that don’t generate cash flow and therefore rely on debt to fund growth, get hit especially bad. Those types of companies, which also offer the promise of stronger earnings down the line, watch that future potential growth become less valuable.

In the past, we've discussed two of the most common ways that investors use to value stocks, Discounted Cash Flow (DCF) and valuation multiples, and how they're affected in an inflationary and/or higher interest rates environment. Let's revisit to help navigate these treacherous markets.

Today’s dollar is worth less tomorrow

Essentially, a DCF model forecasts what future earnings (cash flows) are worth today.

A dollar today, will always be worth more than a dollar tomorrow. The reason is inflation. A dollar 10 years from now, simply will not have the same buying power it does today. In 1970, a bottle of coke was $0.05, compared to $2.0 today.

A DCF model uses an investor’s required rate of return in an attempt to determine what that future profit is worth to an investor today. For example, should an investor expect a company to generate $1 a year from now, and they want a 10% rate of return, they will discount that $1 by 10%. As a result, to get $1 in profit next year, the investor is willing to pay $0.90 today.

The rate of return that investors demand is influenced by the US Treasury Yield. Most commonly, the 10-year Treasury yield is used on Wall Street as a risk-free rate of return. Investing in US Treasury is considered risk-free because it is backed by the U.S. government. In contrast, investing in stocks (equities) is considered risky because the company can go bankrupt. If one can get 3% yield on the 10-year Treasury today which is safe, they will demand a higher rate of return to invest in equities which are risky. 

In 2020 - 2021, when the 10-year yield was at 1%, investors may have demanded a 10% rate of return (arbitrary). In 2022, because the 10-year yield has gone up to 3% (because of reasons discussed at beginning), investors would want higher than 10% (perhaps 15%). When you discount that $1 a year from now by 15%, you get $0.85 as the fair value the investor is willing to pay (compared to $0.90 if discounted by 10%). 

Say that $1 wasn’t coming in one year, but instead coming in two years. When the 10-year yield was at 1%, the investor would discount the $1 twice by 10%, resulting in a present value of about $0.83. Now, since the 10-year yield is at 3%, they discount twice by the 15% rate, resulting in a present value of about $0.76.

Now consider, in the first example, where the $1 was only a year out. When the required rate rose from 10% to 15%, the present value dropped from $0.90 to $0.85, representing a roughly 5.5% decline in the present value. In the second example, however, where the $1 in earnings is two years out, the rise in the required rate of return causes the present value to fall from $0.83 to $0.76, meaning that the $1 being an additional year away now causes a nearly 8.4% decline. Point being, the impact of rising rates, and the resulting impact on the return an investor requires, will have a greater compounding effect on what an investor is willing to pay for stock in company today, the further out the profit expectations are.

The effect of this discounting gets larger the longer out the earnings are in the future. A dollar two years from now would be discounted twice than a dollar next year (duh). Since high-valuation, no-earnings, dream-based stocks are often predicated on being "of the future," their earnings are years in the future. Therefore, unlike their value peers that generate profits today and tomorrow, the impact of rising rates has an outsized impact on the former names. We discussed a clear example of Rivian (dream) vs Ford (now) here. 

How much to pay for tomorrow’s earnings

The other way to value a stock is based on its price-to-earnings multiple.

Given that the multiple represents what an investor is willing to pay for stock in a company based on its earnings stream, it contracts when interest rates go higher. It shows that investors are not willing to pay as much for that same earnings stream as they did in a lower rate environment.

Remember, rates rise to reflect inflation expectations. When inflation is rising, that earnings stream is worth less than when rates were lower (low inflation expectations).

Another way to think about this is to invert the price-to-earnings multiple, which provides us with an earnings yield. For example, consider a stock trading at 20x earnings. That means that an investor is spending $20 for every $1 in earnings. Flip that and we get 1/20 or a 5% earnings yield.

Now, an investor may have been happy to receive a 5% earnings yield when the risk-free rate was 1%. However, when the risk-free rate rises to 3%, they may not find the risk of holding that equity worthwhile given how much the gap between the risk-free asset and the risky asset has narrowed.

Demanding a higher earnings yield is the same as valuing the stock at a lower multiple. But thinking about it this way makes the comparison a bit more direct.

What happens when investor sentiment turns

Inflation expectations aside, rising rates also reflect a tightening of Federal Reserve's monetary policy — usually to prevent unstable inflation.

As the Fed tightens, either through interest rate hikes in the short term or reducing the balance sheet (which has a greater effect on longer-term rates such as the 10-year), economic activity slows. Car and home loans, mortgages, student loans all become more expensive, therefore reducing economic activities. When economic activity slows, businesses don't make as much money: it’s harder for Ford to sell more cars when customers don't have the purchasing power. 

As a result, in addition to inflation and risk-free rate, multiples may also contract to reflect expectations that earnings will decrease — and as a result, the stock may be more expensive than it appears. For example, if a stock trades at $20 based on a $1 earnings per share estimate, reflecting a 20x P/E multiple, but an investor thinks that the earnings are likely to come in at $0.90, they may sell the stock down to $18, reflecting a 20x multiple on the $0.90 they expect. 

In addition to the lower earnings expectation, multiples may contract even further when the news actually come out, because of negative momentum/ sentiment. Rather than paying 20x on the $0.90 expected, since the economy is slowing, the outlook is less certain, the investor would only be willing to pay 18x on that $0.90.

This double punch on earnings and sentiment would cause that stock to trade down to $16.20, at 18x $0.90. That is why the environment we are seeing is so brutal right now, despite a mostly solid earnings season. Sentiment is taking a hit and concerns are growing over future earnings estimates.

That’s how a 10% cut in earnings from $1 to $0.90 can result in a 19% drawdown for a stock, or for a major average such as the S&P 500. This is indeed the current debate for the S&P500 as we approach the second half of 2022, when market participants are beginning to forecast what earnings will look like in 2022, and what the appropriate multiple is to place on those earnings. The problem is, the combination of inflation, rising rates, Russia/Ukraine, mid-term elections, and whether or not a recession is going to occur, make this an incredibly difficult job. 

Bottom line

All of the uncertainties aside, remember what the widely-trusted Warren Buffett said, "be fearful when others are greedy, and be greedy when others are fearful." Investors are selling stocks wholesale because they are unsure of the economic outlook in 2022. But think about what if any of the fear factors gets resolved, be it inflation actually peaks, the Fed becomes less hawkish, Russia-Ukraine war ends, and the economy remains strong. It's not good to invest with hope when the market is at all-time high. But the market is not at all-time high; in fact, it is so oversold that it does not make sense to sell now. 

The reason we continue to stay the course and put money to work is because we believe that this moment will pass. The way I see it, in my lifetime, if the market could weather the 2000 dot-com bubble, the 2008 great recession, and the 2020 Covid pandemic, this is nothing. 

The question is, which companies survive and come out strong on the other side? We clearly are not buying unprofitable, no-earnings, story stocks that are based on future promises; they will not work today and will not work tomorrow. We are buying companies that have strong earnings and large cash flow today, this moment. We are placing trusts in management teams with proven track records. We are thrilled to see these companies come down to historically-low, reasonable valuation multiples. We remain disciplined and patient for the light at the end of the tunnel, that's when our horses, be in Ford Motors, Advanced Micro Devices or Disney will run.