Wednesday, March 31, 2021

My thoughts on Nasdaq vs Bond Yield

It’s been a busy month for me with work; hence, I didn’t have time to do any research on any stocks. So to keep this blog alive, I will just share my thoughts on the current Nasdaq performance and its relation to the bond yield. 

The bond yield has been creeping up since July 2020 and sending its 20-year yield to an all-time high of 2.27% (as of 26 Mar). As interest rates are inversely proportional to bond prices, rises in interest rates mean lower yield bonds will drop in price to match current interest rates. Usually, sell downs in bonds signify expectations of economic recovery and inflationary pressure.

Economic recovery should be a boon to the stock market, and that is evident with Dow Jones Industrial Average hitting an unprecedented high; however, the opposite is true for technology stocks in Nasdaq.

Many analysts reason that this is due to a rotation out of high growth technology stocks (Netflix, Apple) to value stocks (Chevron, Boeing) as the economy begins to open up. Another reason for this decline is that higher bond yields result in higher risk-free rates, leading to higher equity risk premiums. Equity risk premiums are generally used in the computation of the expected rate of return in stocks and this has a greater impact on growth stocks. Since technology stocks are focused on growing their topline, they will only generate significant cash flow in later years. So when discounting to present value, their intrinsic value drops significantly.  

Despite the two reasons mentioned above, I am still confident that tech stocks will continue to grow and will grow faster. In the words of Satya Nadella, CEO of Microsoft, “We've seen two years' worth of digital transformation in two months.” Covid-19 has merely accelerated digital transformation where one conducts meetings via Zoom, browses new clothes without leaving their house, purchases life insurance policies without the hassle of face-to-face meetings and comfortably works from home.

Google CEO is considering hybrid models for future work
https://www.cnbc.com/2020/09/23/google-ceo-sundar-pichai-considering-hybrid-work-from-home-models.html

It is true enough that there will be more employees going back to the office to work after the economy reopens and business travel resumes to some extent. But some changes could be long lasting.  Consider this: how many companies will stop accepting online payment or PayNow and go back to cash and cheque mode? Or, how many companies will close down their e-commerce platform to start a brick-and-mortar store? Not to mention, Tesla has started accepting Bitcoin. The genie is out of the bottle and there is no turning back. Companies like Zoom are still in their early days. What is seen as a video conferencing platform will permanently replace business meetings and disrupt the corporate travel industry, and its open source ability allows it to be used for telehealth or education. 

Secondly, I believe theory of reflexivity is at play here (to some extent). This was famously used by George Soros in his book The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means. Soros argues that investors make decisions on their perception of reality rather than reality itself. These decisions in turn affect the reality that influences investors’ decisions. This is self-reinforcing and causes the stock market to move in either direction that is detached from fundamentals and actual economic situations. In our case, rising bond yields result in inflation fears, triggering sell off in bonds and tech stocks and leading to a further drop in bond prices and tech stocks. This adds to investors’ concern that inflation fears are underappreciated, causing more selloffs in tech and bond markets. 

Economic improvement is certain in the coming few months and Consumer Price Index and inflation are expected to peak in May at 3.7% and 2.3% respectively, based on the forecast from Action Economics; however, these numbers do not accurately represent economic recovery. May 2020 falls within the start of the shutdown in the US and many countries, so we are comparing CPI and inflation at their lowest - the numbers would inevitably look optimistic. Hence, the third or fourth quarter’s CPI could be a better indicator of economic recovery. 

Come to think of it, inflation just means too much money chasing too few goods, and should inflation stay above 2%, consumers will feel confident to spend more and take on more debt. This leads to increase in demand, and that increase could also mean more demand in online shopping or gaming, which in turns benefits tech stocks.

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