Rising Interest Rates May Be Leading To Revaluations In Stock, Bond, And Housing Markets

Key Takeaways:

• Equity Index Futures Bounce Back From an Overnight Selloff as Investors Try to Hang on to the Gains
• Stocks Fell on Tuesday as Interest Rates and Oil Prices as well as a Rare Miss by Goldman Sachs
• Investors Are Forced to Re-Evaluate Valuations When Interest Rates Rise

Stocks are looking to rebound on Wednesday from Tuesday’s selloff as equity index futures are pointing higher. Futures fell overnight but rebounded with European markets. London’s FTSE 100, Germany’s DAX, the French CAC 40, and the Stoxx 600 traded higher. However, there’s a number of earnings announcements for investors to sort through on Wednesday. Financial companies continue to dominate the reports, but there are other companies of note.

Starting with the financials, Morgan Stanley MS (MS) and Bank of America BAC (BAC) both beat on earnings estimates despite missing on revenues while U.S. Bancorp TBBK (USB) missed on top and bottom line numbers. These stocks were moving in premarket trading with MS rallying 2.38%, BAC climbing 2.62%, and USB falling 4%. According to Barron’s, BAC appears to have had the best quarter because of its ability to control expenses.

Outside of financials, UnitedHealth UNH (UNH) reported better-than-expected earnings and revenue but only rallied 0.35% in premarket action. The healthcare and insurance company has been able to stave of higher expenses from rising COVID-19 Omicron cases. Revenue in the company’s Optum health-service grew 14% in the previous quarter, increasing to $41.1 billion.

The supplier of industrial, construction, and safety products Fastenal FAST (FAST) beat on earnings and revenue, prompting a 1.9% rise in premarket trading. FAST, it seems, has not been hurt by rising inflation, and a company like FAST that specializes in selling a lot of low-priced items like screws, nuts, and bolts may be seen by some investors as a good indicator of demand and economic strength. FAST also announced a dividend increase.

After the close on Tuesday, trucking company J.B. Hunt (JBHT) announced better-than-expected earnings and revenue despite lower hauling volumes due to COVID-19-related labor shortages, inclement weather, and train derailments. The company reported a 22% revenue increase per load, excluding fuel surcharges. JBHT rose 0.10% in after-hours trading.

The question for the day is, “Can we hold the higher levels that equity index futures are pointing to?” It has been a challenge to hold the gains especially in the first half hour.  However, yesterday’s selloff was very orderly and never really got “out of control” which could signal that investor are simply revaluing assets in the light of rising interest rates and not panic selling.

Sell Away

Rising interest rates and oil prices, with a few misses by big financial companies like Goldman Sachs (GS GS ), appear to have been too much for investors who were selling stocks on Tuesday. The VIX (Cboe Market Volatility Index) rallied 18.76% to 22.79, reflecting a rise in investor uncertainty around the financial markets. The S&P 500 (SPX) fell 1.84% as investors sold stocks. However, investors were also selling bonds, driving the 10-year Treasury yield (TNX) up 5.25% to 1.865%. In contrast, the 10-year yield was closed at 1.343% on December 3, 2021, which was its most recent low.

The major stocks indices are lower so far this year. The Dow Jones Industrial Average ($DJI) is down 2.7% year to date. The S&P 500 (SPX) has fallen 4%. The Russell 2000 (RUT) has dropped 6.6%, and the Nasdaq Composite (COMP: GIDS) is nearing correction territory after closing 7.3% year to date on Tuesday.

An asset that investors appear to be buying is crude oil. Oil prices rose 2.74%, breaking above its November 2021 highs and creating a new seven-year high. Rising oil prices seemed to help energy stocks, which was the best-performing sector on a day when all other sectors finished in the red. Rising rates normally help financial stocks, but they were the worst-performing sector on the day thanks to earnings misses.

The 2-year Treasury yield also rose above the 1% mark. Some investors may see this as a sign that the Fed is going to have raise rates more than Chairman Jerome Powell had originally targeted. After the December Fed meeting, Chair Powell said that the Fed was targeting 0.90% by the end of 2022. The 2-year yield tends to be the most correlated with the Fed’s moves, which is why investors are now looking at the potential that the Fed may have to raise rates higher and sooner. The CME FedWatch Tool is currently discounting a 91.6% chance that the Fed will raise the overnight rate by a quarter of point in March.

The Valuation Variable

When interest rates rise to a certain level, many investors revalue their investments and alter their price targets. This is because stock valuation tools like the discounted future cash flows model use interest rates to help determine a company’s intrinsic value. The intrinsic value is a measure of what a company or asset is worth. The model looks at the rate of earnings growth for a company over a certain period and then discounts those earnings into present value dollars using the “risk-free” rate of return, which is commonly the 10-year Treasury yield. The higher the yield rises, the less those future earnings are worth.

But, the 10-year yield isn’t the only factor that can change valuations. Rising business costs like inflation and rising borrowing costs from higher interest rates could also reduce the estimate for future earnings growth or reduce the price multiple that investors are willing to pay for the stock. There are other variables at stake when calculating intrinsic value, but interest rates are an important one.

Valuations are likely the biggest driver helping the S&P 500 Pure Value Index’s recent outperformance of the S&P 500 Pure Growth Index. On November 19, 2021, the value index surpassed the growth index in relative strength. Since that time, the value index has rallied more than 8%, while the growth index has falling nearly 14%. The S&P 500 has also fallen a little more than 2% over the same period. And, apparently, investors are finding the most value in energy stocks because the Energy Select Sector Index has risen 20% in the same time frame.

A group to watch could be the pandemic stocks because investors are struggling to value these stocks if we return to a more “normal” pre-pandemic lifestyle. Many of them like Zoom (ZM) and Peloton (PTON) are struggling to find a landing spot. ZM is down more than 70% from its pandemic high in October of 2020 while PTON is down more than 80% from its January 2021 high. Investors may have trouble pricing these stocks going forward because of the uncertainty around the business climate.

Yielding Ground: My technical analysis friends tell me that we can use long-term charts to get an idea of how much more interest rates could rise. The 10-year Treasury yield recently broke above its 2021 highs or resistance. The next level of resistance is likely around the 2% level. Depending on how long it takes for the yield to reach resistance, it could mean more volatility for stocks in the short term.

Breaking Bonds: Rising yields also means that the bond market is likely to keep falling too because bond price and bond yields move in opposite directions. However, rising yields will eventually pull income investors from other assets that pay higher dividends like utility stocks or real estate investments trusts (REITs). This is because higher Treasury yields and safety associated with government bonds tends to be more enticing to income investors. In the last three months, we’ve seen this play out. The Utilities Select Sector Index rose about 10% but topped out in at the turn of the new year and has fallen more than 4%. Similarly, the Real Estate Select Sector Index had risen about 13% going into the new year but is now down about 7.5%.

Mortgaging the Future: The housing market could also feel some pain because the 30-year mortgage rate is commonly correlated with the 10-year Treasury yield. The 30-Year Fixed Rate Mortgage Average in the United States closed last Thursday at 3.45% according to FRED, but this morning the Mortgage Bankers Association reported the 30-year mortgage at 3.64%. To put this into perspective, the 30-year mortgage hit its bottom on January 7, 2021 at 2.65%.

According to SFGate, a 0.25% increase on a mortgage rate could add roughly $20 to the monthly payment for every $100,000 on the loan. Of course, with the build up in the homebuilder backlog, a little less heat may be welcomed by homebuilders and their suppliers, which is one of the reasons why the Fed is raising rates.

So far, the housing market appears to be holding up. This morning, the December building permits came in higher-than-expected. While housing starts were lower than the previous month, they were higher-than-expected in December too.

TD Ameritrade® commentary for educational purposes only. Member SIPC.