Correlation of the 5-year treasuries (FVX) and NASDAQ Composite (COMPX)There has been a lot of talk this week about how market conditions are changing and that the approach over the last year (more or less) is changing. Apparently, the “there is no alternative) to investment in stocks” no longer seems to hold water today, in that bonds now are providing an actual alternative. I’m a relatively new investor (about to retire and so can start focusing on my portfolio), so I don’t know how in-depth I am getting when I say that I find the recent correlation between the 5-year treasury yield and the NASDAQ Composite to basically be tracking each other inversely – at least, yesterday, Friday, February 26, 2021. Pulling up my brokerage chart this morning I see that the NASDAQ started dropping at market open while the 5 year bond was increasing in yield from 9:30 am to 10:30 am. At 10:30, bonds reversed and so did NASDAQ. Incredible how this tracking goes. Looks like the algos in the markets are tuned in totally to the 5-year. Same thing happened from 11:10 eastern to 11:30 eastern. Peak yield for the date was at 11:30 and then it reversed lower throughout the day; however, stocks at 11:30 ended the day at 4:00 pm at the same level. Does this mean that the algos are keyed on the sell-side only when rates increase, but are not hair-triggered to buy when rates reverse? I’m a buy and hold guy, but I’m realizing that reading into some of this might give me some advantage.
Takeaways for me:
1. Treasury rates really matter right now
2. Lot more correlation / reaction (cause and negative effect) for NASDAQ when yields increase then when the rates decrease, i.e., a delayed and not as equal reaction when the buy side condition occurs.
3. The jawboning from the talking heads about the rates and their importance is something that I’m not discounting.
Like many of you this week, I took a hit of 18 percent. My small caps were creamed….
Anybody have any thoughts? Am I saying something basic, something prophetic, something in-between? Channeling Dick Cheney, I know what I know and I know what I don’t know. I just don’t know what I don’t know.
I welcome your thoughts … before Monday, I hope!
And thanks, Travis, I lurked in your forum for a couple of months. I appreciate your work.
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There is typically a short-term correlation between rates and stock prices, as you noticed, and one of my market hedges is a bet on rates rising quickly — if rates rise slowly, the stock market can absorb that to some degree, but quick changes feed right into everyone’s forecasting models and freak people out.
There are lots of reasons, part of it is TINA (there is no alternative), with bonds getting some appeal back when rates return to at least close to the rate of inflation, but there are also a lot of interrelated dynamics at work — when people sell stocks they reflexively buy short-term bonds to park their cash, when rates go up it tends to hurt some sectors of the economy, and, in the case of growth stocks, rising rates make the future more appealing than the present.
If you are basing your argument for a stock on the sales and earnings you expect them to have in 2025, for example, rather than the business they have today, then your model shifts that value based on interest rates — if rates are zero, a future dollar is worth almost as much as a dollar today. If rates rise to “normal” something or other, above the rate of inflation, then that future dollar is worth much less. At a 1% discount rate, $100 in five years is worth $95 today… at a 4% discount rate, $100 in five years is worth $82 today. Put that into an excel model with all your other forecasts about a company, and relatively minor adjustments in your estimates about where interest rates are going can pretty substantially alter your view of the current value of the investment.
What looks on a chart like a perfect long-term correlation, of course, is probably going to be a lot bumpier in real life, but you have certainly hit on one of the major dynamics that investors seem to be worrying about in recent weeks. Sentiments change quickly, and the Federal Reserve still has tremendous power over the whole spectrum of interest rates with both their words and actions, so it probably wouldn’t take that much of a crisis to shift sentiment back to the “interest rates will be zero forever” panic.