One of the most prominent themes in financial markets this year has been the rise of interest rates and the negative impact they have had on high growth stocks.
The Ark Innovation ETF (ARKK), a strategy full of fast-growing companies, lost nearly a third of its value in a matter of weeks in January as rate worries reached a crescendo. ARKK is down more than half from its highs of a year ago, however, much of those losses came after November when interest rates really started spiking in earnest.
As can be seen from the chart below, ARKK’s free fall began that month, when the two-year US Treasury yield eclipsed 0.5%. ARKK kept falling over the course of the next few months as the two-year yield breezed past 1% for the first time in two years:
ARKK vs 2-year US Treasury yield
All else equal, rising interest rates make growth stocks less attractive for various reasons. For instance, cash flows in the future are worthless when discounted back to the present at a higher rate while stocks, in general, become less attractive relative to bonds when rates go up.
That said, over the long term, there is no one-to-one relationship between rates and any category of stocks. For shorter periods of time, correlations can and do exist (see the chart above).
But inevitably, those relationships break down. The risk-free yield is only one input into stock valuation. The equity risk premium – the excess return above the risk-free rate that investors expect from holding stocks – is often a much more significant driver of how stocks are priced. That is especially the case in what is still, by historical standards, a low rate environment.
The equity risk premium is volatile and can be sentiment-driven, leading stock prices to overshoot on both the upside and downside.
That may be why even though interest rates have continued to move higher over the past week or two, high growth ETFs like ARKK have not fallen further. Bearish sentiment has already pushed the ETF to an 18 month low, erasing much of its post-pandemic gains.
In other words, investors may have already priced in – or more than priced in – today’s level of interest rates. So, it is conceivable that rates could continue to march higher and the ETF could stand still or even go up.
That’s not a prediction; just an acknowledgement that stocks tend to overshoot in both directions and “price in” events ahead of time.
On the flip side, ARKK could just as well continue lower, particularly if the fundamentals of its holdings deteriorate. After all, interest rates are not everything. Underneath the hood, there is a portfolio of stocks representing real companies. The performance of those companies will be the most significant driver of the ETF long term.
This story was originally published on ETF.com
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