A couple of notes before the actual substance–thank you for refraining from chuckling–of today’s column: Today’s stock-market action was actually quite fascinating to watch, especially once the early-day plunge was out of the way. Unlike yesterday, when stocks fell in unison, there was a meaningful divergence between stocks today. The most obvious example of this was the contrast between the Dow’s rise and the Nasdaq’s fall, but the more interesting example was that by the end of the day most (though, not all) of the tech powerhouses–that is, those with profits–had recovered sharply and were actually up on the day, while most (though again, not all) of the Internet high-fliers, in both the e-retailer and B2B camps, were down, often sharply. As I suggested on Monday, this kind of divergence is a good and comforting thing, since it suggests investors are distinguishing between companies rather than throwing them all into one big buy-or-sell pot.
The other good–and comforting–thing was that both the New York Times and the Washington Post led with Greenspan’s reappointment rather than with the market sell-off. (I realize I wrote about the sell-off yesterday instead of Greenspan, which might seem to be discomfiting by my standards, but I’ve already issued too many hosannas to the Great Alan for another one to be interesting. Until the next one, of course.) For that matter, the Daily News put the Turner-Fonda separation on its front page. These seemed like nicely measured, and somewhat surprising, reactions to what might have been played as a much scarier event than it really was.
One crucial ingredient in all of today’s explanations of the sell-off (and we are now entering the putatively substantive part of the column, so watch your heads) was, of course, “interest-rate concerns.” Unfortunately, it’s usually not explained why people who are investing in stocks should be all that concerned about interest rates. In fact, they should be–and are–concerned. It’s just that the reasons for their concern are complicated, because interest rates affect stocks in different ways and, for that matter, because there are different interest rates to be concerned about.
The interest rate that most journalists have in mind when they talk about “interest-rate concerns” is not the interest rate that you see at the bottom of that bug in the corner of the CNBC screen. That’s the interest rate on the 30-year U.S. bond. The rate most journalists are talking about is the federal funds rate, which is the interest rate the Federal Reserve raises or lowers in order, in theory, to speed up or slow down the economy by increasing or shrinking the size of the U.S. money supply and indirectly raising or lowering interest rates on things like car and home loans (since banks pass along changes in interest rates to their customers). It now appears that the Fed will raise interest rates at its February meeting, and of late investors have got it in their heads that instead of its typical 25-basis-point (0.25 percentage point) increase, the Fed is going to hike rates by 50 basis points.
These interest-rate concerns, then, are concerns that the Fed’s actions will slow down the economy, which in turn will make corporate profits grow less quickly than otherwise, and since investors are paying prices for stocks that assume very fast profit growth in the future, the threat of a slowing economy makes them want to sell.
Fair enough. But one of the odd things about this most recent sell-off is that, with the exception of banks (which are always hit hard by interest-rate worries), the hardest-hit companies were those companies whose profit prospects will be the least hurt by a fed-funds hike. If you’re a big retailer, or an aluminum company, or even a car company, an interest-rate hike could have–though I stress could–a big impact on your business. But if you’re Cisco (which I own) or another major supplier of technological infrastructure to big business, you’re going to weather anything short of a complete recession, because American business shows absolutely no sign of cutting back on investment. And that’s because in this competitive environment, it can’t.
So why would interest-rate concerns hit the high-priced tech stocks so hard? You might ascribe it simply to panic, which undoubtedly played a part. But there are also two other reasons, which have to do with that other interest rate, the one on the 30-year bond. That interest rate is effectively the risk-free rate of return for any investment you want to make, and as the interest rate on bonds rises, bonds become more attractive and stocks less attractive. This has a practical consequence, which is that rising rates lead institutions–primarily, at this point–to pull money out of the stock market and put it into bonds. And the opposite is true when rates are going in the other direction.
But rising rates also have a theoretical consequence that’s even more important. If you want to figure the present value of a stock–which is to say, how much it’s worth today given how much free cash flow the company is going to generate in the future–you need to discount that cash flow by your required annual rate of return. (If your required rate of return is 10 percent, then the total free cash generated by the company in 20 years needs to be divided by 1.1 to the 20th power.) And a crucial component of that rate of return is the interest rate on the 30-year bond, since you know you can get that without any risk at all.
If interest rates rise, then, the present value of the future cash generated by the company–even if the amount of that cash is unchanged by the rise in interest rates–shrinks. Even a relatively small rise in interest rates can have a major effect on that present value if it’s spread out over 30 years. And since the stock prices of the most valuable companies in the world today in fact reflect investors’ confidence that they’re still going to be generating huge amounts of cash 30 years from now, rising interest rates can have serious effects on current stock prices.
In the end–although you’ll hear plenty of people tell you that this is an old-fashioned idea–a stock’s price is a mechanism for discounting the future. And as the discount rate rises, it’s not surprising if stock prices fall. The equation is not automatic or perfect. But in the long run, it’s unavoidable.