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Investment Commentary

You May Hate Math

By Brian Andrew | Johnson Financial Group • February 02, 2022

6 minute read time

Markets have been very volatile since the year began. Whether you are invested in stocks, bonds, real estate, cryptocurrency, or any other asset, you’ve seen tremendous volatility in prices. It may seem like everything is down. However, that is not the case. Let’s explore where this volatility is coming from and what’s changed since the beginning of the year to create an abundance of it. And, while you might hate math, we’re going to use some to explain the markets’ volatility.

First, Math

There are several methods for valuing a stock; let’s use a simple one, the dividend discount or Gordon growth model. This model says the value of a stock, its price, is a function of a company’s potential future earnings (paid out as dividends) discounted by a required return rate minus the growth of those dividends. The formula for a stock price then looks like this:

The formula for a stock price then looks like this:  P=Stock Price; D=Dividends; r= required rate of return and g=growth rate of dividends (or, if all cash is paid out in dividends, then the growth rate of the company’s cash flow).

P=Stock Price; D=Dividends; r= required rate of return and g=growth rate of dividends (or, if all cash is paid out in dividends, then the growth rate of the company’s cash flow).

Now imagine a market where people feel good about the return they’re getting because interest rates are near 0% and anything is better than that. And company growth is accelerating because companies are improving earnings and cash flow as they recover from the 2020 beginning of the pandemic. Sounds like 2021 doesn’t it?

If you change both the sentiment regarding the required rate of return and prospects for dividend growth in a short period of time, then the outcome of the formula above becomes less clear. When we say markets don’t like uncertainty what we really mean is they don’t like not knowing what “r” and “g” are going to look like in the future.

What Happened To “r”

As we entered 2022, it was clear that the Federal Reserve was going to leave the markets’ party. The Fed was forecasting an increase in short-term interest rates and said it would reduce purchases of bonds, which adds liquidity to the financial system (like oil in a car engine).

Because people are obsessing about whether inflation is transitory or permanent, and because interest rates have been near 0% for so long, any change in interest rate levels creates uncertainty. Those who believe that inflation is here to stay want more interest rate hikes from the Fed because they believe it will cool the economy and lower inflation.

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Because the Federal Reserve has a hard time being clear about future intentions, markets’ perception of how much rates would rise has changed rapidly. Look at the yield on the 2-year Treasury in the last three months. 

Look at the yield on the 2-year Treasury in the last three months. It has risen from less than 0.4% to 1.16%, and almost half of that move took place since the beginning of the year. When interest rates rise, the required return for stock investors must also rise; that’s our “r.”

It has risen from less than 0.4% to 1.16%, and almost half of that move took place since the beginning of the year. When interest rates rise, the required return for stock investors must also rise; that’s our “r.”

Back to our formula. If a company pays $5 in dividends per share and was expected to return 10% and grow at 5%, its price would be $100 per share. If the rate of return required is now higher by one percentage point because interest rates are moving up, and everything else is the same, the price would be $83 per share—that is, 17% lower. Now imagine people believe growth may slow from 5% to 4%. This coupled with that higher required rate of return means the price is near $71. Our hypothetical stock has experienced a 29% decline because of a slight change in the required return and the slowdown in growth.

Now back to reality. In a matter of three weeks, investors have begun to think that the Fed will raise rates more quickly, pricing in another hike or two in 2022. They have also begun to believe the economic slowdown will accelerate due to higher prices stemming from higher energy prices and labor costs (so, lower growth). Plus, investors have quickly come to believe the required rate of return for stocks needs to be higher (given higher interest rates). As you can see from the example above, these changes in both “r” and “g” are not a great combination for stock prices.

And “g”

We touched on “g”—but now let’s take an even closer look at it.

Of course, it’s true that growth is slowing. In 2021, the economy was recovering from the depths of the pandemic in 2021 and as a result, the U.S. economy grew by more than 6%. That level of growth was not sustainable. In 2022 we believe we’ll return to a more normal level of growth, though still elevated. This growth should support company earnings, albeit not at last year’s levels of 49% on average for S&P 500 stocks. Earnings may grow by 8% this year, not more than twice that amount.

Growth stocks, i.e., those stocks representing companies whose cash flow and earnings growth are much better than the market, have seen their prices decline more than most in the last several weeks. Some of these were the “stay-at-home” darlings of the pandemic.

Netflix stock is down 37% since the beginning of the year. The company recently projected subscriber growth to slow by four million people during the first quarter. Other stay-at-home stocks like Zoom (-25%) and Peloton (-33%) have fallen quite a bit as well. And if we looked at a longer time horizon, we’d see even bigger losses.

That’s the problem with growth stocks. When everyone believes that “g” will keep moving higher, growth stock prices are bid up to unimaginable valuations. Then, when the momentum disappears, they fall quickly. That’s what we’ve seen this year.

Not everything has lost money. Energy stocks are up! XLE, the energy ETF, has returned 18% since the beginning of this year. And while the financial services sector remains relatively flat this year, better net interest margins are likely to help those companies. In fact, if you remove the technology sector, the S&P 500 Index is down only about 4% this year, not nearly 9%.

The Math Matters

As we enter 2022, the uncertainty surrounding economic growth, corporate earnings growth and the future for interest rates has led to tremendous volatility. However, as we’ve stated earlier, economic growth could be stronger than the long-term average, inflation may have peaked, and corporate earnings are likely to be sound. As you can see from how much “r” and “g” affect stock prices, as long as these values are uncertain, volatility may persist.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Johnson Wealth Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE