By Mark Hulbert
Higher U.S. interest rates threaten the so-called FAAMG stocks. I’m referring to Facebook /zigman2/quotes/205064656/composite FB -1.14% , Apple /zigman2/quotes/202934861/composite AAPL -1.17% , Amazon.com /zigman2/quotes/210331248/composite AMZN -1.38% , Microsoft /zigman2/quotes/207732364/composite MSFT -1.97% and Google (Alphabet) /zigman2/quotes/202490156/composite GOOGL -0.67% , whose combined market caps now represent a quarter of the S&P 500’s /zigman2/quotes/210599714/realtime SPX -0.84% total. The source of this growth in valuation has been largely a mystery — until now.
Recent research shows that declining interest rates are helping to fuel these companies’ higher valuation. Rising rates, therefore, could cause these mega-cap stocks to lose market value.
This conclusion is just the opposite of what you would otherwise suspect. You’d think that lower interest rates would disproportionately help smaller companies and those that are barely surviving, so higher rates should hurt them more. But that isn’t what this new study found.
Entitled “ Falling Rates and Rising Superstars ,” the study’s authors are Thomas Koren, Ernest Liu and Atif Mian of Princeton University and Amir Sufi of the University of Chicago. The National Bureau of Economic Research began circulating the research earlier this week.
The researchers reached their conclusion after constructing two hypothetical portfolios. The first, the “Leaders” portfolio, was constructed to contain the stocks of just those firms that were in the largest 5% of companies in an industry. The second, the “Followers” portfolio, contained all others. The relative performances of these two portfolios between 1962 and 2019 were then correlated with changes in the 10-year U.S. Treasury /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y 0.00% yield.
The researchers found that when the 10-year yield declined, the Leaders portfolio outperformed the Followers portfolio. This performance advantage widened at an accelerated pace when U.S. interest rates were particularly low.
How big an advantage? Consider how much faster the leaders’ market caps would be expected to grow if the 10-year yield declined to 1.0% from 2.0%. Based on data from 1962 to 2019, the researchers estimate that this rate decrease would result in a 5.3 percentage point increase in the market valuation of the Leaders portfolio relative to the Followers portfolio.
No wonder that the largest companies in recent years have to come to represent an ever-bigger share of the overall stock market. From the turn of the century to its low last year, the U.S. 10-year yield fell to 0.5% from 6.5%.
Just the reverse can be expected when interest rates rise. That’s why the FAAMG stocks are now at risk of losing market share; the 10-year yield has been rising, to 1.6% currently from 1.2% last August.
Why do lower rates help the biggest companies gain market share? In an interview, Sufi identified two major reasons:
Lower rates reduce the borrowing costs of the Leaders more than for the Followers, and the Leaders take advantage of it. When rates fall, they proportionally borrow more money and their leverage increases. The Leaders in turn make more capital expenditures relative to the Followers, undertake more cash acquisitions, and invest in more property, plants and equipment.
Lower rates reduce competition, according to the researchers, because they induce the Leaders to become super-competitive. That’s because their future earnings become more valuable in present-value terms as interest rates decline, leading them to “go for the kill” in their competition against their rivals. Companies that previously were able to hold their own against the Leaders now find it much harder to keep up.
This new research has both investment and government policy implications. For investors, the study suggests that the largest stocks will struggle when interest rates are rising.
The policy implications trace to the anti-competitive consequences of low rates. The new research suggests that low rates may actually not be expansionary, as is often assumed, but actually “contractionary.” That’s because they are anti-competitive, leading to increased concentration and possibly weak investment and low productivity growth.