Interest rates and Earnings : March 2021 experience and Tactical Investment ideas

I) The reason growth stocks suffer more with abruptly rising interest rates

The valuation of every investment should correspond to the present value of future cash flows . If we invest in a house, in education or in a stock we expect positive cash flows for several years and should compare them with the cost of Investment. We buy if the present value of the estimated future cash flows is higher than the price paid  and sell if the price to be paid exceeds the expected stream of cash flows.

The current practical side of the relation and the stock market implications in order to buy  stocks is as follows : 

A) we need a high level of earnings. 

We are getting them due to the expansionary policies.

B) we need a high growth rate expected to exist for several years. 

We also hope to experience them.

C) we need low interest rates to discount the future cash flows.

We have a headwind here that hopefully will be contained.

Sectors of the market have a different reaction to the abrupt  increase in interest rates. The present value of growth stocks, based on their high earnings in the distant future, loses a lot in value when discounted with higher interest rates.

Therefore, 

Tech, biotech and new economy stocks relatively underperform.

Industrial, consumer discretionary, industrials, energy, materials, smaller stocks rely more on the higher earnings  in the near rather than in the distant future.

Value that has lagged growth in recent years  resumes its focal interest.

II) The  Macro policies create two areas of serious concern : 

A) strong expansionary fiscal policy, as the one proposed now to fight COVID, can lead to inflation. Even some  democratic renowned economists think this policy might create an inflationary spiral and are against it (Summers) . The administration (Yellen and Powell) is in favor to promote spending and fix the infrastructure.

We do not know the exact future reaction of the economy to a rise in Demand (the exact shape of the Supply curve). After long, variable and uncertain time lags and the human behavioral reactions to policy initiatives we will find out! The hope is to experience mainly an expansion in output  with minimal increase in inflation !

B)The FED thesis on continuing easy monetary policy has two effects :

1. the short term rates obviously remain low.
2. the longer term rates increase as it is feared that inflation will return by taking a dovish stance now.

In this case financial stocks that borrow cheap (short term rates) and lend higher (longer term rates) benefit. They should be well represented in the portfolios.

C) We should not forget the  negative impact of higher rates on Housing, Bonds, possibly on stocks and therefore on spending. Eventually, growth might be affected.

This is one of the reasons that free market economists believe that macro policies do not have lasting effects.

The exact magnitude  on the economy in the shorter run of the interest rate rises  depends on human reactions. It is always difficult to forecast the exact effects on investment and consumption , especially in this unprecedented environment recovery environment.

D) Trading ideas.

On the buy side :

ETFs    Major stocks 

IVE       BRK, JPM, BAC, DIS, INTC, JNJ, VZ, CVX (RD)     Leading Value Stocks 

XLI       BA, HON, CAT, MMM

XLB      DD

XLY      AMZN NKE 

XLP     PG, PEP

On the sell side :

Technology has to be trimmed gradually to avoid increasing overall exposure.

If cash is available the sell side can be contained.