“US Tech stocks decline as rates rise.” That was a prominent headline today, and simple valuation math supports the idea:
- Technology stocks typically have high valuations, which means markets are imputing many years of rising and relatively risk-free future cash flows.
- As Treasury/risk free yields rise, the discount rate on those cash flows also increases. That leads to lower valuations.
- Simple example: a perpetuity of $100/year discounted at 5 percent is worth $2,000 ($100/0.05), but the same $100/year discounted at 6 percent is only worth $1,667 ($100/0.06).
- Just a 100 basis points change in discount rates is worth 17 percent to valuation.
But … Does this simple model reflect how capital markets actually work? To stress test this idea, we did the following:
- Pulled daily price and return data back to 2011 for TLT (the +20-year Treasury ETF), XLK (S&P 500 Tech sector), PSCT (S&P 600 Small Cap Tech sector) and the S&P 500 itself.
- Ran trailing 100-day price return correlations for large cap tech/long term Treasuries, small cap tech/long term Treasuries, and the S&P 500/long term Treasuries.
What we expected to see: a positive 100-day return correlation between both large and small cap Tech stocks and long dated Treasuries, and a stronger correlation to bonds for Tech versus the S&P 500 overall. This would fit with the mathematical model presented above. Higher yields = lower bond prices = lower tech stock valuations.
What we got was the exact opposite:
- Over the last 10 years, the mean correlation of 100-day returns for US large cap Tech to +20-year Treasuries is negative 0.32. Yes, negative. This makes for an r-squared of just 10 percent, implying very little cause and effect between rates and large cap Tech valuations.
- The mean correlation of 100-day returns between US small cap Tech and +20-year Treasuries is negative 0.35. The r-squared here is just 12 percent.
- The correlation between the S&P 500 and +20-year Treasuries is actually higher than both large and small cap Tech, at 0.39. That’s an r-squared of 15 percent.
Now, before you say “Aha! All the pundits are wrong!” there’s one more piece of this analysis worth noting: the return correlation between the US tech sector/S&P 500 and long-dated Treasuries varies quite a bit across time. That’s what the two charts below show, but here is a quick description of the data:
- While S&P/large cap tech stock return correlations to long-term Treasuries are usually negative to the tune of -0.4 to -0.6, they can occasionally turn modestly positive.
- This happened, for example, in Q4 2016/Q1 2017.
- Why? Because long-term Treasury yields were rising quickly over this period. 10-year yields went from 1.5 percent in July 2016 to 2.6 percent in March 2017. That was a sharp enough move to take large cap Tech correlations to long-term Treasuries from negative 0.3 to positive 0.3 from September 2016 to January 2017.
- This year is another example of higher bond/large cap Tech stock correlations. We started 2021 with essentially zero trailing 100-day return correlations between these two asset classes. Correlations peaked in early July at 0.32, and have actually been drifting lower since. For the most recent 100 days, they are at 0.05.
Takeaway (1): daily returns for US large cap Tech stocks have been tied to moves in long-dated Treasuries for much of this year. Today’s outsized move in 10-year Treasury yields, and back above the important 1.5 percent level, fits that narrative. At the same time, the historical record clearly shows that Tech stocks: 1) only rarely correlate so closely with bonds and 2) periods of positive correlations are relatively short (5 months in 2016/2017, the only other example aside from the current environment in the last 10 years). We’re coming up on 8 months of positive correlations right now.
Takeaway (2): we do not think it is wise to be short/underweight Tech just because yields are rising. Earnings are the other piece of the valuation equation, and this group has a proven track record of delivering on that front. On top of that: as the correlation history shows, this group has been unusually levered to the rate outlook all through 2021. Today was not “day one” of tech factoring in higher rates. Unless you think Treasury yields are going straight to 2 percent or higher, Tech stocks are likely market performers through year end in our view.