Low Interest Rates Amplify Volatility by Seth J. Masters, John McLaughlin, Pavan W. Auman
In today’s rock-bottom interest-rate environment, small changes in growth expectations can have an outsize impact on stock prices.
One of the most common ways to value a stock is to discount its estimated future cash flows (such as earnings or dividends) by the prevailing interest rate. If the rate is low, as it is today, the present value of its future cash flows will be greater than in a normal rate environment.
What’s more, any change in a company’s growth trajectory will lead to a disproportionate change in its valuation: Low interest rates magnify the impact on present value of any increase (or decrease) in future cash flows.
For example, consider a company that launched a new hit product and is now expected to grow its dividends by 1% more annually as a result. The company’s value would increase by 33% in today’s low interest-rate environment, as shown by the teal bar on the left side of the Display. Applying the same methodology in a normal interest-rate environment would yield only a 17% increase—meaningful, but not nearly as dramatic.
Interest Rates vs Volatility
The same relationship would be evident on the downside if the company’s product launch flopped. The bars on the right side of the display show that if expected growth is 1% slower, the stock’s valuation would decline by 20% in today’s low-rate environment, far more than the 13% decline you’d see under normal rate conditions.
Increased Potential Rewards For Stock Selection
The heightened sensitivity to earnings growth changes makes the current, low-rate environment ripe for active management, by increasing the value that stock selection can add: If a manager’s growth expectations for a stock differ from consensus, the stock price may be undervalued (or overvalued) by a significant amount. If the manager’s insight is correct, the stock will outperform (or underperform) as market pricing adjusts to reflect the new information.
Consider Facebook,* an industry favorite with high-consensus growth forecasts. We believe the market may be underestimating its full growth potential. The company is exploring ways to allow businesses to automate customer service using its messaging platform. What’s more, the company’s “instant articles” have the potential to give it greater control over advertising.
It remains to be seen how much Facebook will profit from these new platforms, which makes it difficult for analysts to include them in their growth forecasts. Yet, in our view, management’s successful track record implementing new projects means these latest endeavors could hold the keys to an upside surprise and a revaluation.
But Risk Management Is Crucial
Expectations for growth are always a moving target, so price volatility for individual stocks and the overall market is likely to be high for as long as rates remain low. Managing through this type of volatility will require an active hand.
In a normal environment, there’s only a 7% chance that a moderate growth portfolio, with 60% in stocks and 40% in bonds, would fall 20% from peak to trough at some point within the next 10 years. Today, the likelihood of such a large drawdown is 24%, more than three times the rate in a normal interest rate environment..
Given the increased volatility that we expect to see, it is critical investors give careful thought to managing risk within stock portfolios and at the asset allocation level, in order to manage risk and optimize potential outcomes.
*This example is provided for the sole purpose of illustrating how research can be used to help identify investable ideas. It should not be assumed that investment in any specific security was or will be profitable. It does not represent all of the securities purchased, sold, or recommended for clients in a particular Bernstein product.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.