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We know the reason the market’s down. Do you?

yes, obviously more people willing to sell at a lower price is the mechanics...

Author

Tim Vollans
September 25, 2023 • Estimated Reading Time: 6 minutes

The stock market’s down. Here’s what’s causing that weakness:

🧠 The Big Brain
Dude, I’m Selling Duration

… is one of those lines that maybe 1% of the global population understands.

Yeah cool story bro, but wut the fink are you talking about?

Torture can be fun in a safe environment so let’s take the FinSpeak one level further and then we can break it down. Here’s Goldman Sachs:

Short duration stocks have outperformed long duration equities during the latest leg higher in bond yields, as the discount rate and growth effects both work against long duration stocks.

Meme Reaction GIF by Travis

OK, enough waterboarding. Like most things in finance, this duration stuff isn’t as complicated as it sounds. But it IS important to know.

All we need to do is bring a few important concepts together.

First up, stocks are, generally speaking, priced on some measure of their future revenues.

If a company relies more on future (expected) earnings, it’s a long duration stock. Typically these will be fast-growing companies (also why they’re known as growth stocks)

If a stock relies more on present earnings, it’s a short duration stock. Typically these are companies that have exited their rapid growth phase & matured into stable revenue generators.

Check out this video from Tim Sunderland comparing Tesla & Ford to see the difference(s):

@mittomarkets

Are Tesla shares overvalued? Hot topic of debate 👀 All the data you see is from Stockopedia, click the link in my linktree to receive a 2... See more

Tesla = long duration stock (exciting future, more potential, less certain)
Ford = short duration stock (know what you get, established, more certain)

Right, now to explain the discount rate and why it’s important.

To discount cash flows, you need a discount rate

Michael Mauboussin, Dan Callahan (& Warren Buffett) explain:

“ . . . the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was ‘a bird in the hand is worth two in the bush.’

To flesh out this principle, you must answer only three questions.

- How certain are you that there are indeed birds in the bush?

- When will they emerge and how many will there be?

- What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)?

If you can answer these three questions, you will know the maximum value of the bush — and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.” Aesop knew that everything is a DCF model.

Nothing new under the sun.

So, there’s always a lot of guesswork going on, but you basically take the expectations of a company’s future cash flows & apply the ‘discount rate’ to figure out how much you should pay for the prospect of there being birds in the bush.

i.e. what return could I get if I simply buy a ‘risk free’ US treasury bond (the bird in the hand)

That number now stands at 4.5% to 4.6%…

Now, this hasn’t weighed especially heavily on duration stocks until very recently. Arguably because of the other side of the equation.

Back to Goldman’s spiel:

Short duration stocks have outperformed long duration equities during the latest leg higher in bond yields, as the discount rate and growth effects both work against long duration stocks.

Rising bond yields matter more to stock prices when growth stalls.

In Goldman’s words:

the negative discount rate effect of higher yields on long duration stocks is often partially offset by improving growth expectations

Rising oil prices and a more hawkish ‘higher for longer’ Fed are both expected to be a drag on growth, which could explain why the consumer discretionary basket (longer duration) fell by 7.3% last week.

Summing up, the current combination of growth slowing while oil & bond yields rise isn’t a positive one for long duration stocks.

⚡ The Spark
Respect The Lags

Everyone’s heard the phrase “monetary policy works with long and variable lags” - Friedman’s quote has been parroted by many an economist.

Sooooo, why does everyone keep ignoring it?

Here’s Minneapolis Fed head Neel Kashkari:

"Consumer spending continues to exceed our expectations- I would have thought with 500 basis points or 525 basis points of interest rate increases we would have slammed the brakes on consumer spending, and it has not."

Every cycle is different, but only ONCE in history have recessions started earlier after the first rate hike (we’re currently at 18 months):

Coming on the back of a period when so much cash was pumped directly into consumers accounts, along with wage rises & continuing government spending, is it such a surprise that the economy has responded so little to rate hikes so far?

The current narrative is of a ‘quadruple threat’ to growth:

U.S. Economy Could Withstand One Shock, but Four at Once?

A year of surprisingly strong growth is about to be tested by a strike, the possibility of a government shutdown, student loans and oil prices.

www.wsj.com/economy/u-s-economy-could-withstand-one-shock-but-four-at-once-8312ba51

PLUS the lagging impact of higher interest rates…

💡 The Lightbulb
Chicken Or Egg?

Hot topic in the community today…

Which is the bigger driver of a nation’s economic prospects?

The underlying culture or the politics?

Some argue that the politicians create the culture. Others argue that the culture creates the politicians (i.e. “we get the politicians we deserve”)

I’m firmly in the latter camp. Politicians are chameleons that will adapt to the culture of the time to secure votes…

Am I wrong?