Here's why stocks investors like us care so much about bond yields

Published Fri, May 13 20222:46 PM EDT

"The 10-year Treasury versus the stock market: Who wins today?" Jim Cramer posed that $1 trillion question in his morning note to Club members on Wednesday . We say $1 trillion question because that's how much big tech stocks lost in market value in a recent three-day stretch as the benchmark 10-year Treasury yield soared above 3% to highs 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 in the current environment because inflation is bad for bonds and we've got tons of inflation. In fact, consumer prices in April, while growing a tad bit slower, came in this week still around 40-year highs . Then add in traders who 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 leave inflation roaring even as the economy slows. At a high level, many types of loans are pegged off the 10-year yield and/or the Fed's policy interest rates. So when yields and rates go up, so does the cost of borrowing money. That's where stocks get a double whammy. Inflation, in general, takes a bite out of corporate earnings and higher borrowing costs hurt companies, particularly growth names of which many are in tech. So-called growth stocks, particularly the profitless high fliers that don't generate cash flow and therefore rely on debt to fund growth, get especially hit because higher rates makes it more expensive to borrow money to fuel growth. Those types of companies, which also offer the promise of stronger earnings down the line, watch that future potential growth become less valuable. There are two ways that investors can value stocks in a rising rate environment, using what's called discounted cash flow, or DCF for short, and forward price-to-earnings multiples. We've looked that these two approaches in the past. But we wanted to revisit how they can help members navigate these treacherous markets. Today's dollar is worth less tomorrow Essentially, a DCF model forecasts what future earnings, or cash flows, are worth in the here and now. A dollar today, will always be worth more than a dollar tomorrow. Put another way, the further out into the future a profit stream is, the less it is worth in present-day money. The reason is inflation. A dollar 10 years from now, simply will not have the same buying power it does today. Don't believe us? Ask your parents what a bottle of Coca-Cola cost when they were a kid. A discounted cash flow 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 require a 10% rate of return due to their investing profile — the risk they are willing to take — they will discount that $1 by 10% and determine that a fair value to pay for that dollar in the future, is $0.90 today. It's important to understand that the 10-year Treasury yield is used on Wall Street as a proxy for a risk-free rate of return. That's why investors will demand a higher required return for the risk they're taking on by investing in equities versus Treasurys issued and backed by the U.S. government. So, that investor who may be demanding a 10% rate of return when the 10-year yield was at 1%, may now demand a 15% return since the 10-year, the "risk-free rate", trades currently around 3%. 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. The effect of this discounting compounds the further out the earnings stream is in the future. So, since high fliers are often flying high because of grand promises down the road — unlike their so-called value peers that we prefer that generate profits today – the impact of rising rates has an outsized impact on them. Say that $1 wasn't coming in one year, but instead coming in two years. Originally, the investor would have taken the $1 and discounted back twice by 10%, resulting in a present value of about $0.83. Now, however, they must discount back 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. How much to pay for tomorrow's earnings The other way to value a stock is based on its price-to-earnings multiple. We previously provided an in-depth look at how this model works and how it's applied. So, instead of reviewing that, we want to simply discuss the impact rising rates may have on the 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, which represent the cost of money, 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, and if inflation is on the rise, that earnings stream is no longer worth what it once was because inflation is eating away at it over time, more than it otherwise would have when rates were lower, which reflects low inflation expectations. Another way to think about this is to invert the price-to-earnings multiple. Doing so 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 yield 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, the Treasury yield, and the risky asset, the equity, 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, we must be mindful as we mentioned earlier that rising rates reflect a tightening of Fed monetary policy — usually to prevent inflation from running too hot and higher costs. As the Fed tightens, be it through rate hikes on the short end or unwinding the balance sheet (which has a greater effect on longer-term rates such as the 10-year, economic activity slows. Auto loans, mortgages, student loans, and outstanding variable rate loans of all kinds become more expensive to service. If economic activity slows, then the ability to generate earnings becomes more difficult – it's harder to sell that same home or car when the loan rate increases because the monthly payments go up. That's a dynamic that reduces demand and results in fewer homes and cars being sold. It also means that companies may tighten budgets, hire less or layoff workers. All of this trickles down into corporate profits. So, multiples may also contract to reflect expectations that the earnings estimate will need to move lower — and as a result, the stock is 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. The earnings simply have not caught up yet. Of course, nothing is that clean and in addition to the lower earnings number, the multiple will likely contract even on the new figure to reflect the more negative sentiment. Rather than the investor saying, "I will pay 20x the $0.90 I expect estimates to be revised down to," they may say, "the economy is slowing, the outlook is less certain and I do not know when things will improve, as a result, I am only willing to pay 18x what I believe will be $0.90 in earnings." This one-two 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 major average such as the S & P 500 — which is also often valued based on a consolidated earnings estimate and appropriate multiple. Regarding the S & P 500 that is, indeed, the current debate, as we approach the back half of 2022 when investors are beginning to look out to next year to determine what earnings will be and what the appropriate multiple is to place on those earnings in an attempt to calculate a year-end price target. The problem is, the combination of inflation, rising rates, Russia/Ukraine, mid-term elections, and whether or not a recession is in the cards near-term, make this an incredibly difficult, if not nearly impossible exercise and that is how you get the kind of volatile environment we have now. Bottom line All of that said, the reason we stay the course is because unless you believe the world is ending — and before you say it is, consider how many times the world has already "ended" over the past 100 years — you must believe that this too will pass. The question is, which companies survive it and come out strong on the other side? The answer to that question is where you must focus your buying power. That's why we focus so intensely on earnings releases, it allows us to focus on our investments, drown out the noise, and better determine which companies are effectively executing and growing through this period, despite what the stock price may indicate. (Jim Cramer's Charitable Trust is the portfolio we manage in the Club. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

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Scott Mlyn | CNBC