Roger Lee
From 2009-2021, U.S. stocks (particularly the mega-capitalization “FAAMG” stocks; Facebook (now Meta Platforms), Apple, Amazon, Microsoft and Google (now Alphabet) were driven by the rallying cry, There Is No Alternative (“TINA”), in reference to an unprecedented era of ultra-low interest rates and massive liquidity fueled by the Federal Reserve (“Fed”). Bond yields approaching 0% forced investors out onto the risk spectrum and turn to “riskier” assets like stocks in hopes of generating returns.
This all came to an abrupt halt in 2022, with soaring interest rates in response to persistently sky-high inflation reminding investors There Are Reasonable Alternatives (“TARA”) to stocks for generating portfolio returns once again. The regime change from TINA to TARA has sweeping implications for every investor that we’d like to summarize in preparation for 2023.
The most readily apparent effect of TARA is the rebirth of risk-free returns. With the Fed’s target for short-term interest rates currently at 4% (likely peaking around 5% next year), investors can once again earn decent nominal returns with no risk. After a long hiatus during TINA, FDIC-guaranteed CDs and government bonds are once again an attractive place to park idle cash, while earning 4-5%. Civic-minded investors are also returning to tax- exempt municipal bonds, where yields of 4-5% have pushed tax-equivalent yields north of 7%.
On the downside, the road from TINA to TARA has led to one of the worst years in history for the U.S. bond market. As interest rates rise, bond investors demand higher yields, crushing the price of previously-issued bonds now paying below-market rates. Indeed, supposedly “safe, investment-grade” bonds have shed almost $3 trillion in value. While the bloodbath in bonds has been devastating, investors can once again earn reasonable income lending to the government or their favorite “blue chip” companies.
Warren Buffett famously said, “it’s only when the tide goes out that you learn who has been swimming naked.” Indeed, ultra-low interest rates were the tide that lifted all boats. The end of TINA’s reign was marked by a bubble in highly speculative assets, from initial public offerings (IPOs), to special purpose acquisition companies (SPACs), to “meme” stocks (GameStop), to cryptocurrencies and nonfungible tokens (NFTs).
During TINA, individual investors were driven by the fear of missing out (“FOMO”) as prices soared “to the moon.” What financial titan John Pierpont (J.P.) Morgan said in the 1800s remains true today; “nothing so undermines your financial judgement as the sight of your neighbors getting rich.” With the return of TARA, FOMO has been replaced by the FOBD (the fear of being decapitated) as speculative assets have come crashing back to Earth (Sam Bankman-Fried’s FTX just the most recent example).
Buffett also observed, “interest rates are like gravity on valuations. If interest rates are nothing, values can be almost infinite. If interest rates are extremely high, that’s a huge gravitational pull on values.”
We think the major silver lining of the return of TARA will be the outperformance of fundamentals-driven, “value” investing versus momentum-driven, “growth” investing. Indeed, as of the end of October the S&P 500 Value Index had a year-to-date return of -7%, while the S&P 500 Growth Index lost a whopping -27%.
A stock represents fractional ownership of a business. Businesses exist to make a profit and the value of any business is the cash it will generate over its life. Period. It doesn’t matter if today’s wunderkind runs the company or tweets about a stock “going to the Moon,” cash is the where the rubber meets the road. The trick for investors is forecasting those cash flows and then applying the appropriate discount rate to determine the present value of that stream, sometimes known as the stock’s intrinsic value.
Intuitively, $1 of profit today is worth more than $1 of profit five years from now. Less intuitively, the discount rate is directly impacted by interest rates and the higher the discount rate, the less future cash flows (particularly those far in the future) are worth today. Going back to Buffett’s observation, with interest rates approaching 0%, investors were able to justify astronomical valuations on high revenue-growth companies that were hemorrhaging cash now, but had a compelling story about how they were going to mint cash in the distant future.
These “growth” stocks had price momentum on their side as they rose steadily and relentlessly higher and the strong wind of ultra-low interest rates at their back for more than a decade. With interest rates now significantly higher and momentum turning decidedly negative (Meta/ Facebook down a mind-blowing 67% in 2022), these same stocks will now be fighting the gravitational pull of higher interest rates. Conversely, stocks of companies in stodgy/decidedly un-sexy businesses (“value” stocks) that generate a significant amount of profits and cash now will benefit, by comparison.
TINA was fun and thrilling. She made investing seem easy and you feel like a genius. Unfortunately, in the harsh light of day, it was inevitable she was going to break your heart. TARA isn’t nearly as glamorous or exciting, but she’s the one you can happily grow old with.
Mickey Kim and Roger Lee are chief operating/compliance officer and senior research analyst, respectively, for Columbus-based investment adviser Kirr, Marbach & Co.. They also write for the Indianapolis Business Journal and can be reached at 812-376-9444 or [email protected] and [email protected].
