In my August 13th Market Commentary, I discussed the conditions that would be required to finally see a rotation out of the mega-cap technology stocks. This is an important topic because these five stocks have grown so large (to $7.3 trillion in combined market capitalization) that their future performance, whether positive or negative, will have a major impact on overall stock-market performance. If these behemoths shift from leading the indices higher to becoming a drag on performance, their sheer size (which now represents nearly 24% of the S&P 500) has made it increasingly more difficult for the remaining universe of stocks to make up for that drag. Furthermore, it is likely that as the five tech behemoths go, so will the sectors in which they reside (Information Technology, Communications Services, and Consumer Discretionary). I believe that investors, by and large, are underestimating this risk.
I said that one or both of the following conditions will precipitate a rotation out of the mega-caps: 1) evidence that the economy is strengthening in a sustainable way, and/or 2) a more meaningful increase in longer-term interest rates. Today I’d like to pick up on that discussion about interest rates. But first some definitions: “Nominal” interest rates, which are the rates that the federal government must pay investors upon the issuance of debt, have two components: the inflation rate and the inflation-adjusted, or “real” interest rate. If we know what the inflation rate is, we can determine the real rate by subtracting the inflation rate from the nominal rate. The Consumer Price Index, or CPI, is most commonly used measure of inflation (though there are many others). The most recent reading on CPI was 1.0% for July, meaning that consumer prices rose 1.0% in July compared to July, 2019. Therefore, if the yield on the 10-year Treasury note was 0.53% at the end of July, we know that the real rate of interest was -0.47% (or 0.53% minus the inflation rate of 1.0%).
Nominal interest rate = real interest rate + inflation rate
The chart below tracks real interest rates over the past two years (blue bars). The orange line is an index we created that contains the five mega-cap stocks (FB, AMZN, AAPL, GOOGL and MSFT). We used a one-month lag for the mega-cap index to show how the performance of these massive companies is inversely correlated to real interest rates. In other words, when the real rate of interest goes up, the mega-cap index goes down (and vice versa). I would specifically like to focus on the area shaded in green. Over that period of about 14 months, real interest rates fell by about 2.4% from +1.2% to -1.2%. During that same time frame the mega-cap index rose by 71%, meaning that the average increase of those five stocks was 71%. That bull rally was interrupted by the COVID outbreak, during which the average mega-cap stock fell by 25% and the inflation rate fell to about 0%. Since that time, though, real interest rates are back to negative again as inflation has picked back up. Predictably, the mega-caps are back on a tear as well.
Allow me to digress for a moment. To be very clear, the mega cap tech stocks are not only doing well because of very low interest rates. These companies, by and large, have great balance sheets and business is booming due to the nature of the COVID recession. Farr, Miller & Washington owns the names in this group that fit its discipline (e.g. solid long-term secular trends, prospect for above-average earnings growth, fantastic balance sheets, solid free cash flow generation, great management, and reasonable valuations). We DO NOT typically own the large tech stocks that trade at nose-bleed valuations, generate little in the way of real earnings, or sport leveraged balance sheets. Ok, back to the topic at hand…
It is widely expected that the Fed will announce a decision to move to “average inflation” targeting at Chairman Powell’s annual address in Jackson Hole on Thursday. What does that mean? Jeff Cox of CNBC put it succinctly in an article published on CNBC.com on Monday: “Simply, it means that the Fed, which has pegged 2% as a healthy level, will let inflation run higher than that for a while if it has spent a considerable time beneath that level. The Fed’s preferred inflation gauge has stayed below that level for all but two years since the Great Recession ended in mid-2009.” Given the Fed’s failure to reach its inflation target for eight of the last 10 years, are we to assume that the central bank will now let inflation run hot for the lion’s share of the next decade? If the Fed does allow inflation to run at 3% or even 4% while simultaneously keeping nominal interest rates very low through Quantitative Easing, what will be the effect on real interest rates? The answer is that they will plummet further into negative territory.
If inflation is indeed picking up – and that is a big “if” – and the Fed remains committed to keeping short- and long-term interest rates near zero, the central bank needs to be ever so vigilant about creating financial dislocations (read: bubbles), the likes of which led to the two recessions prior to the current one. In other words, if negative real interest rates have been highly correlated with strength in these mega-caps, which already represent 24% of the S&P 500, what will be the effect of the further suppression of real interest rates to perhaps -3% or -4%? And the rumor is that the Fed wants to commit to keeping interest rates near zero for another 5 years! We don’t think the Fed should make such commitments given the dislocations that are already apparent.
The truth is that we don’t know what is going to happen. No one knows. Investors face enormous uncertainty right now. The divergence of opinion on the direction of interest rates among professionals is astounding. Will the increase in the supply of money lead to massive inflation? Or, will the lack of velocity of that money keep inflation at bay? Will the depth of the recession lead to deflation? Or will supply chain issues caused by COVID and increased protectionism lead to inflation? Farr Miller deals with this uncertainty by 1) ensuring that each client portfolio has an asset allocation that reflects an appropriate amount of risk, 2) building diversified portfolios of reasonably priced, high-quality securities that should provide solid growth during good times and downside protection during bad times.