Bond Math Reveals the Secret of Big Tech’s Fate in the US Stock Market

(Bloomberg) — Want to know where the world’s biggest technology stocks are headed? Just look at one of the oldest measures out there: the bond market.

That is increasingly the refrain of some investors after a season of rising corporate profits has done relatively little to protect companies like Apple Inc., Facebook Inc. and Netflix Inc. much further forward.

Few significant catalysts can be seen on the immediate horizon to boost the already record-breaking stock prices of the US tech giants, with the rising Delta variant dominating the outlook for everything from commodities to emerging market bonds.

So a cabal of Wall Street analysts and investors are turning to Treasury yields for clues.

Those returns can be used in mathematical models to discount the value of for-profit companies in current dollars. The higher those returns go, the smaller the present value of those gains can become.

While that affects all companies, it’s especially important for high-growth companies whose stock prices are more dependent on the big profits they’re expected to make well into the future. Shares of such companies received an additional boost after the outbreak of the pandemic, as the Federal Reserve’s efforts to avoid an economic collapse caused government bond yields to fall, making those future gains look even more attractive.

“If interest rates go up, they will underperform,” said Aash Shah, senior portfolio manager at Summit Global Investments, of the largest technology stocks. “That’s nothing against their business, just a reality of discounted cash flow.”

The trade-off between technology stocks and Treasury rates is, of course, nothing new; For example, the surge in yields in 2018 contributed to an outrageous defeat in the Nasdaq 100 Index at the end of that year. And other forces, such as last year’s shift away from companies hit hard by lockdowns, have also played an important role in boosting technology stocks.

Chris Murphy, co-head of derivatives strategy at Susquehanna International, said a rise in interest rates does not necessarily pose a risk to technology stocks if economic growth remains strong. But that could be overshadowed if investors fear the expected pullback in the Federal Reserve’s bond-buying program.

“If economic growth holds up, the 10-year yield and the Nasdaq could converge,” he said. “If the focus shifts to the Fed tapering, it’s bad for the Nasdaq and the relationship starts to get more negative.”

Fed Chair Jerome Powell is expected to remain vague about the timing of the central bank’s phasing out of asset purchases at Jackson Hole’s annual economic symposium later this week.

Less exposure

The recent boom in technology stocks has come as Treasury bill prices have risen. The yield on 10-year government bonds has fallen by almost half a percentage point since the end of March. The Nasdaq 100 gained 17% over that period, outperforming the S&P 500 index by more than four percentage points. The Nasdaq 100 hit an all-time high on Tuesday along with the S&P 500.

Exclusive Inc. the so-called Faamg shares have gained even more. Google parent company Alphabet Inc. increased by 37% over the same period. Microsoft Corp. is up 28%, while Apple Inc. and Facebook both gained more than 20%.

Strategists at Citigroup Inc., who expect 10-year yields to climb to 2% as the market approaches 2022, advised this month that investors reduce exposure to technology stocks due to the risk of higher interest rates.

At the same time, the sector’s earnings growth is expected to contract in the coming quarters, creating potential headwinds. Tech companies in the S&P 500 have so far reported a 47% increase in earnings compared to the same period a year ago. But analysts expect growth to slow in each of the next four quarters, according to data collected by Bloomberg Intelligence.

Jason Benowitz, senior portfolio manager at Roosevelt Investment Group, is skeptical that the outperformance of technology stocks can be sustained.

He expects yields to rise as the Fed gets closer to scaling back its monthly purchases of government bonds and mortgage-backed securities, which have injected massive amounts of cash into the financial system. He said this would put pressure on so-called mega-cap tech stocks, which have few other catalysts before the Christmas shopping season kicks off.

“It’s hard to get excited about the world’s biggest tech companies against that backdrop,” he said.

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