Why Do Interest Rates Matter for Stock Prices?

Government Bond Prices

We've had a sharp correction in markets in the past week and specifically in Technology stocks as the Nasdaq was down 10% from its all time high earlier in February. This selloff was largely triggered by a sharp rise in government bond rates in the US. But what does government bond prices have to do with stock prices? Well as I'm going to show you, it kind of makes sense, but then it really doesn't make any sense, but then again it kind of does make sense after all.

Here's what I mean: The price of all investment assets is based on how much cash it will put into the pocket of its owner. This is especially true for stocks, bonds, or real estate which generate earnings and produce cash for their owners. But it is even true for investments that do not produce cash. People buy gold when they think gold prices will go up and they will be able to sell that gold for more than what they paid for it. So the ability of an investment to put cash in your pocket is the basic fundamental premise of valuing an investment.

Time Value of Money

Now, it's a bit more complicated than that. There is something called Time Value of Money. Time Value of Money basically means that money in the present day is more valuable than money in the future. We can prove this is true because if you had money today, you could invest that money and you would have the original principal money PLUS whatever investment returns you earned in the future. If I gave you $1,000,000 today and you invested it in a risk free government bond paying 1.5% (compounded annually) at the end of 10 years you would have $1,160,540.83, AND you would not have taken any risk. If I gave you $1,000,000 in ten years you would have $1,000,000 in ten years.

Figure Out How Much the Investment Will Earn You

Clearly, getting the money today instead of in 10 years is better. So now that we have these two concepts down, we actually have the basic tools to do a valuation of an investment. The steps are: Figure out how much cash the investment will earn you, from now until the end of time; and Discount the value of those cash flows back to the present day. Figuring out how much cash an investment is going to pay you in the future is a tremendously hard question to figure out, but it is not really difficult to understand. It simply means how much cash will you get.

The second step is a little bit harder to conceptualize. Because we have time value of money, we know that money now is worth more than money in the future. Usually when you are purchasing an investment, you are purchasing it now, so it's the present day value that matters. In order to figure out what future cashflows are worth to us, we need to bring them back to the present day. We do this by using what's called a discount rate.

What is a Discount Rate?

A discount rate is actually just the opposite of the compound interest calculation I did above. Instead of moving into the future and figuring out what an investment will be worth, we're just moving backwards in time. When you do a compound interest calculation you add in the interest on each payment date. When using a discount rate you are effectively deducting the 'interest' as you move closer to the present day.

Let's do an example so it's easier to understand. Using the same example as I did above we know that $1,000,000 compounded annually at 1.5% will become $1,160,540.83 in ten years. 1.5% is the interest rate on the bond we invested in. The calculation we used to get the value after ten years is: $1,000,000 x (1 + 0.015)10 = $1,160,540.83 Essentially we multiplied the interest rate by the principal value 10 times over. We add a 1 so that the interest is being added to the original principal. Now when we move in reverse and deduct a 'discount rate' the calculation is: $1,160,540.83 / (1+0.015)10 = $1,000,000.00 Instead of multiplying by the interest rate, we are simply dividing. The discount rate we are using is just the interest rate on the bond we could invest in.

Now here's where it starts to make sense that bond rates can impact stock prices. In our example above we used the interest rate of a risk free government bond as our discount rate. Well many people in the real world do exactly the same thing. So whatever the bond rate is at any given time will impact what discount rates those investors are using when they are valuing investments. The way that discount rates work is the higher the rate, the lower the present day value of an investment. You can try it above. Try dividing $1,160,540.83 in the above calculation by any rate higher than 1.5%. You will get a value of less than $1,000,000.

Bond Rates Go Up, Discount Rates Go Up

Nothing has changed about how much money you will have in the future, but if we use a higher discount rate, then that money will be worth less to us in the present day. So when bond rates go up, that means that the discount rates investors are using to value investments are also going up. That also means that pretty much all investments are worth less in present day value. And that's exactly what we saw this past week.

Bond rates spiked, and that lead to everyone adjusting their discount rates, which led to them valuing stocks lower, which lead to selling. So this makes sense, kind of. Except for the fact that the stocks that came down the most were technology stock which tend to have high growth. When a company is growing very rapidly, the impact of a discount rate on its valuation is less. In fact for businesses that are growing extremely fast, like tech firms have, the discount rate becomes much less important and almost meaningless.

A mature company which grows predictably at 5% a year will care a lot about what discount rate we are using because it will make a big difference in the current price. A company that is growing at 20% a year will not care very much about what the discount rate is, because the math just makes it much less meaningful to its present day value.

Rise in Bond Yields

So when tv analysts are attributing the rise in bond yields to a drop in the tech sector, this does not really make a lot of sense. Unless. Unless we factor in all kinds of other dynamics that are playing out. Tech stocks have gone up a lot in the past year and investors are probably looking for a reason, any reason, why the party might be over. Rising bond yields is as good an excuse as any. So some people might have been waiting for a reason to take profits.

Quant Investors

Other investors are what we call 'quant investors'. They base their trades not on the underlying businesses but based on over-arching quantitative models. This sounds complicated, because it is. But sufficive to say they have mathematical rules which trigger them to buy or sell. In this case, rising bond yields was a signal to sell. So quant investors started selling as well.

Momentum Traders

Then there are momentum traders who bet on trends in the market. When tech stocks started to drop, the momentum traders started selling or even shorting stocks based on the price momentum that had been created. This further pushes stocks down. Finally, there are a lot (and I mean A LOT) of investors who invest through passive index funds. These people just want to own the index, whatever it is.

When tech stocks go down, they represent less of the index, and therefore index funds will sell their shares in tech stocks to more accurately reflect the index. This selling further pushes the price down which creates another round of selling. These index investors don't have any choice. When the tech stocks go down, they sell them.

I think all of these factors were at play with the recent drop, and I guess you could say that the initial trigger might have been the rise in interest rates. So the story that tv analysts told kind of makes sense, though it was far from the whole story.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.