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Markets got off to a shaky start to kick off the new year. While the major indexes posted weekly losses, the economically sensitive Dow Jones Industrial Average was the relative outperformer, as investors positioned themselves for a year in which the Federal Reserve is expected to raise rates and reduce the size of its balance sheet. In line with the increased focus on rising rates, the tech-heavy Nasdaq Composite was the relative laggard, now more than 7% off the all-time high reached in November.
Ultimately, we are not that surprised by the action and believe it to be in line with our view that in 2022 you want to own the stocks of companies that "do stuff and make things" while avoiding the "story stocks," i.e., the high-flying, longer-duration, concept names with little-to-no earnings power.
Remember, stocks are valued on future earnings and cash flows. We generate a present value for companies by estimating these outyear numbers and then discounting them to the present day using a discounted cash flow (DCF) model. When rates are at essentially zero, the discount rate (the denominator in a DCF model) is minimal and as a result, investors can speculate and look out into the future as far as they want — because the value in the future is essentially the same as today's. But when rates rise, the discount rate (or the rate of return investors require for the risk they are taking on by owning equities) must increase. That increased denominator means that the present value of future earnings and cash flows declines. The further out those earnings are, the less they are worth today with every tick higher in rates.
An example of how rising rates impact valuations:
To better illustrate this, let's consider an example of how a higher discount rate impacts future earnings.
Company A is a high-flying tech stock (think something in the EV space that came public via SPAC or an enterprise software company) with a promise about the future but no earnings power today, making it a longer duration asset in the context of stocks. Company B is a value cyclical name, like a large-cap financial or industrial. These companies are traditionally thought of as short-duration assets.
Company A is expected to generate $10 of earnings per share in 2027 (five years from now), while Company B is expected to make $10 per share by the end of 2022. An increase in rates means that Company A's earnings are discounted back to the present five full years at a now higher rate, while Company B's must only be discounted back one year at that higher rate.
When rates are on the rise, the impact of discounting to the present day has a larger and larger effect the more years you have to do it. This causes investors to seek out shorter duration assets like Company B over stocks like Company A. Ultimately, A and B will both generate $10 in earnings. However, the present value of company B's $10 in earnings is worth increasingly more relative to company A's as rates rise.
That is why we want to own the stocks of companies that generate real profits today. The closer those profits are to the present day, the less impact rising rates have on their present values, making those earnings more attractive compared with those of the high-fliers that see their present-day intrinsic values drop on higher rates.
Here is a quick look at some of the broader market measures we like to keep an eye on: The U.S. dollar index pulled back slightly but remains just below the 96 level. Gold was about flat on the week, trading at around the $1,800 level. WTI crude prices strengthened to the upper $70s-per-barrel region. And the yield on the 10-year Treasury note had a strong week in response to the Fed's hawkish minutes and decline in the unemployment rate. The 10-year yield now sits at around 1.77%, the highest levels since January 2020.
No portfolio companies reported this week.
In addition to earnings, we received several key macroeconomic updates:
-ISM Manufacturing: 58.7% vs. 60.0% estimate
-ADP Employment Survey: 807,000 vs. 375,000 estimate
-Initial Jobless Claims: +207,000 vs. +195,000 estimate
-Four-week moving average: 204,500 (+4,750 vs prior week)
-Factory Orders: +1.6% MoM vs. 1.5% MoM estimate
- Core Capital Goods Orders: unchanged MoM
-ISM Services: 62.0% vs. 67.0% estimate
What we are watching ahead:
Earnings season kick off next week as the banks are set to report. Within the portfolio, we will hear from Wells Fargo (WFC) on Friday, before the opening bell. Other reports we will be watching include:
On the macroeconomic front, in addition to keeping an eye on the geopolitical sphere as well as for the following releases (all times ET):
10:00 Wholesale Inventories SA M/M (Final)
06:00 NFIB Small Business Index
08:30 Consumer Price Index (CPI)
08:30 Hourly Earnings SA M/M (Final)
08:30 Hourly Earnings Y/Y (Final)
08:30 Average Workweek SA (Final)
14:00 Treasury Budget NSA
08:30 Continuing Jobless Claims SA
08:30 Initial Claims SA
08:30 Produce Price Index (PPI)
08:30 Export Price Index NSA M/M
08:30 Import Price Index NSA M/M
08:30 Retail Sales
09:15 Capacity Utilization NSA
09:15 Industrial Production SA M/M
09:15 Manufacturing Production M/M
10:00 Business Inventories SA M/M
10:00 Michigan Sentiment NSA (Preliminary)
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(Jim Cramer's Charitable Trust is long WFC.)