Despite Falling Stocks and Rising Rates, Mergers and Acquisitions Stay Active

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(Tuesday Market Close) Rising interest rates and oil prices, with a few misses by big financial companies like Goldman Sachs (GS), appear to have been too much for investors who were selling stocks on Tuesday. The VIX (Cboe Market Volatility Index) rallied 18.76% to 22.79, reflecting a rise in investor uncertainty around the financial markets. The S&P 500 (SPX) fell 1.84% as investors sold stocks. However, investors were also selling bonds, driving the 10-year Treasury yield (TNX) up 5.25% to 1.865%. In contrast, the 10-year yield was closed at 1.343% on December 3, 2021, which was its most recent low.

An asset that investors appear to be buying is crude oil. Oil prices rose 2.74%, breaking above its November 2021 highs and creating a new seven-year high. Rising oil prices seemed to help energy stocks, which was the best-performing sector on a day when all other sectors finished in the red. Rising rates normally help financial stocks, but they were the worst-performing sector on the day thanks to earnings misses.

The 2-year Treasury yield also rose above the 1% mark. Some investors may see this as a sign that the Fed is going to have raise rates more than Chairman Jerome Powell had originally targeted. After the December Fed meeting, Chair Powell said that the Fed was targeting 0.90% by the end of 2022. The 2-year yield tends to be the most correlated with the Fed’s moves, which is why investors are now looking at the potential that the Fed may have to raise rates higher and sooner. The CME FedWatch Tool is currently discounting a 91.6% chance that the Fed will raise the overnight rate by a quarter of point in March.

Despite the sell-off, some stocks were moving on merger and acquisition news. Bloomberg reported that Citrix (CTXS) may be a target for Elliott Investment Management and Vista Equity Partners. The news caused Citrix to rally 5.43%. Activision Blizzard (ATVI) rallied 25.88% after agreeing to be bought out by Microsoft (MSFT) for $68.7 billion.

After the bell, J.B. Hunt (JBHT) and Bank of America (BAC) are two of the largest companies reporting earnings. Wednesday morning, UnitedHealth (UNH) and Morgan Stanley (MS) are two of the companies expected to announce before the market opens.

The Valuation Variable

When interest rates rise to a certain level, many investors revalue their investments and alter their price targets. This is because stock valuation tools like the discounted future cash flows model use interest rates to help determine a company’s intrinsic value. The intrinsic value is a measure of what a company or asset is worth. The model looks at the rate of earnings growth for a company over a certain period and then discounts those earnings into present value dollars using the “risk-free” rate of return, which is commonly the 10-year Treasury yield. The higher the yield rises, the less those future earnings are worth.

But, the 10-year yield isn’t the only factor that can change valuations. Rising business costs like inflation and rising borrowing costs from higher interest rates could also reduce the estimate for future earnings growth or reduce the price multiple that investors are willing to pay for the stock. There are other variables at stake when calculating intrinsic value, but interest rates are an important one.

Valuations are likely the biggest driver helping the S&P 500 Pure Value Index’s recent outperformance of the S&P 500 Pure Growth Index. On November 19, 2021, the value index surpassed the growth index in relative strength. Since that time, the value index has rallied more than 8%, while the growth index has falling nearly 14%. The S&P 500 has also fallen a little more than 2% over the same period. And, apparently, investors are finding the most value in energy stocks because the Energy Select Sector Index has risen 20% in the same time frame. 

CHART OF THE DAY: TARGET RATES. The 10-year Treasury yield (TNX) has broken above its 2021 highs and may not find resistance until the 20, or 2%, range. Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Yielding Ground

My technical analysis friends tell me that we can use long-term charts to get an idea of how much more interest rates could rise. The 10-year Treasury yield recently broke above its 2021 highs or resistance. The next level of resistance is likely around the 2% level. Depending on how long it takes for the yield to reach resistance, it could mean more volatility for stocks in the short term.

Of course, rising yields also means that the bond market is likely to keep falling too because bond price and bond yields move in opposite directions. However, rising yields will eventually pull income investors from other assets that pay higher dividends like utility stocks or real estate investments trusts (REITs). This is because higher Treasury yields and safety associated with government bonds tends to be more enticing to income investors. In the last three months, we’ve seen this play out. The Utilities Select Sector Index rose about 10% but topped out in at the turn of the new year and has fallen more than 4%. Similarly, the Real Estate Select Sector Index had risen about 13% going into the new year but is now down about 7.5%.

The housing market could also feel some pain because the 30-year mortgage rate is commonly correlated with the 10-year Treasury yield. The 30-Year Fixed Rate Mortgage Average in the United States closed last Thursday at 3.45%, according to FRED. The 30-year mortgage hit its bottom on January 7, 2021 at 2.65%. According to SFGate, a 0.25% increase on a mortgage rate could add roughly $20 to the monthly payment for every $100,000 on the loan. Of course, with the build up in the homebuilder backlog, a little less heat may be welcomed by homebuilders and their suppliers, which is one of the reasons why the Fed is raising rates.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

Image sourced from Pixabay

This post contains sponsored advertising content. This content is for informational purposes only and not intended to be investing advice.