The valuation of everything
Page 1 of the investing textbook states one should only take risk when one is being rewarded for doing so. This means that the valuation of everything is based off the expected return of the lowest risk asset. It is widely accepted that the lowest risk investment asset available is long dated government bonds. The proxy for this is the 10 year UK government bond in the UK and the 10 year treasury in the USA.
Let’s play out this scenario with broadly made up numbers. If a long term government bond pays you 0.2% a year then you might be prepared to take more risk investing into the stock market, but you would demand to be compensated for this risk with an expected return of lets say 7%.
Bond yields are inversely correlated with price so a rising yields means a falling price.
What happens when bond yields increase by a factor of 4 in two months…………. So your 0.2% per year for a safe bond now goes to c0.8%? Well if you are going to invest into the stock market you expect a return of higher than 7% and all things being equal you might sell some of your stocks and buy the safe bond.
This is the story in the US which is arguably more important given the dollars role in the global financial system. A rising long term yield means the market is making long term dollar borrowing and refinancing more expensive. Here yields have doubled since November 2020.
When everything is priced relative to long term bond yields then if these become more attractive in absolute terms then in relative terms other assets which are inherently riskier are less attractive. This rise in bond yields then has a knock on effect on other assets.
Which assets are impacted most?
The long term bond yield is often used as the discount rate in a very simple and popular valuation model called discounted cash flow model. If this discount rate increases then the value today (present value) of assets with cash returns that are due a long way in the future (think technology shares here) goes down if you are using this model.
If we use Tesla for the posterchild of long duration equity investment (returns expected a long way in the future) then you can see from the chart below how painful the rise in bond yields can be for growth equities from a valuation perspective. Tesla down c30% from peak.
Tech heavy NASDAQ composite down 8% from peak. Indices with lower weightings to growth stocks are down significantly less than the NASDAQ over the same time period.
So far we have only been talking from a valuation perspective and when you consider how important momentum has been for growth shares. If investors suddenly not only value growth shares lower due to the change in discount rate but also want to own them less because they have stopped going up then you can get some pretty nasty price action in the short term. This is what we have seen unfold over the last few weeks.
It is at times like this it pays to have a diversified portfolio and anyone who only owns technology/growth shares will have had a pretty painful couple of weeks. Unfortunately this is exactly the type of portfolio most amateur investors hold.
Opinions constitute our judgement as of this date and are subject to change without warning.