The value of a corporation is best determined by estimating future earnings and then discounting those earnings back to the present at some discount rate. The discount rate for that corporation includes the “risk-free” rate, which is typically the US Treasury rate, plus some risk premium that an investor is willing to take on for investing in that corporation in that industry. For instance, a discount rate could be the 10 Year US Treasury plus 800 basis points. This is how Finance 101 students learn to value a company.

Today’s Problem

The problem we are having in today’s market is that the “risk-free” rate is so low. For the past year, since Covid hit and the Federal Reserve dropped interest rates, Treasury rates across the yield curve have been at or below 1%. Only recently have long-term rates (10 years and longer) risen above 1%, and the 10-Year is at about 1.5% right now. With one element of the corporate earnings discount rate so low, either the risk premium will increase and corporate valuations will remain the same, or risk premiums will remain the same and corporate valuations will increase. A lower discount rate means a higher valuation for those future earnings.

The Past Year

We hit the bottom with the Covid shutdown and stock market correction during the 3rd week of March 2020, which is almost 1 year ago. Since then, it has been almost straight up, with the exception of the past couple of weeks. As of today, the Nasdaq 100 Index is up about 88% since the March 2020 low. That tells me that the risk premium that investors place on the earnings of the Nasdaq 100 corporations has not risen; if anything, it has declined. Consequently, the discount rates for their corporate earnings have declined and corporate valuations have risen – by 88% in this case.

Will This Trend Continue?

I mentioned that the past couple of weeks have not been straight up for the stock market, especially the Nasdaq 100 Index. What has crept back in is a fear of inflation. Investors now realize that all of the actions by the Federal Reserve to buy bonds and to loosen the money supply, as well as the fiscal stimulus bills, including the American Rescue Plan Act of 2021 just passed by Congress, could cause higher inflation. Why? Because together they represent significantly more money in the hands of consumers during a period where there are shortages caused by the Covid economic shutdown. More money chasing fewer goods causes higher inflation, and higher inflation causes higher interest rates. The “risk-free” 10-Year US Treasury rate has risen from below 1% couple of months ago to about 1.5% now. This rise in Treasury rates, caused by fears of increased inflation, is causing jitters for investors, particularly for those heavy in the high-flying Nasdaq 100 index companies. If you assume that earnings in these companies will remain strong but now you have to discount them at 50-60 basis points higher than you did 1-2 months ago, that causes a significant change in what you think those companies are worth today. This change in the corporate earnings discount rate, more than changes in the outlook for corporate earnings, explains why we had a 10% +/- correction in the Nasdaq 100 index from mid-February to earlier this week. The Nasdaq 100 has reversed itself during the past couple of days, but further increases in US Treasury rates could send it down once again.

IMO

I hope this explanation shows you that it is not always changes in the forecasted fortunes of companies that causes stock sell-offs. Instead, it can be changes in the assumptions of how investors mathematically derive their valuations, such as in changes in US Treasury Rates and/or changes in risk premiums. So, don’t blame corporate management at first; blame those old bugaboos, inflation and higher interest rates.