The mystery of stock prices falling despite earnings increasing
“Millions saw the apple fall, but Newton asked why.”
Apple and Nestlé, among many popular large-cap stocks did not perform well since September 2020, despite a rising broad market and favorable earnings releases. Between September 2020 and February 2021, Apple fell close to 10% and Nestlé 12%. Although the most important thing for a stock to perform well over the long term is by far its earnings growth, sometimes, shorter term, this isn’t sufficient to compensate for the other most important factor when it comes to asset prices in general: interest rates. This love and hate relationship between equities and interest rates should, in theory, be very simple to assess: falling interest rates are good for equities as it magnifies future flows, while rising interest rates do the opposite. But this has not been the case all the time; popular “risk-parity” strategies were playing against the maths logic as they were long fixed-income and equities in order to have a protection on possible equity downside thanks to supposedly good returns from bonds when it happens. But this is not what the maths tell you: if the discounting factor (i.e. interest rates) moves higher, then the price of your asset, all else things equal, falls.
And this is precisely what happened during the last 6 months (for some listed companies), as the discounting factor rose quite sharply (US 10 year yield went from 0.7% to 1.47%, 20 year yield from 1.24% to 2.15%). Guess what, maths worked perfectly well this time as long duration equities fell, almost in line with the fall in bond prices like the table above highlights. Apple’s Price Earnings Ratio went from 34 to 27 times 2021 estimated earnings, for Nestlé it moved from 26 times to less than 23. Here’s the proof that although higher yields do not really affect the business of these companies, it definitely has an influence on their valuations. But there are equity sectors which show an inverted correlation compared to what the maths say. First and foremost, financials, the most hatred sector of the last decade. Rising interest rates is good for banks and insurance companies. More broadly, cyclical sectors tend to be shorter duration assets than growth and defensive sectors and logically outperform when yields move to the upside. The very good performance from cyclical sectors since interest rates started to move up was the reason why indices were able to grind higher. This is why a balanced approach in terms of sectors is important. We don’t know if yields will keep on rising, stall or fall; but we do know that building a portfolio of good companies, whatever their sectors, with a nice equilibrium between Value/Growth and Cyclicals/Defensives is the surest way to deliver appreciable returns over the long term.
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