Indiana Trust Wealth Management
Investment Advisory Services
by Clayton T. Bill, CFA
Vice President, Director of Investment Advisory Services

  • The US equity market, represented by the S&P 500 index, slipped 2% for the week ending August 18.
  • Higher interest rates were supposed to torpedo growth stocks in 2023 while providing a relative boost for value stocks. That narrative is being seriously challenged this year.

Growth-style stocks are those with high valuations attached, many of which do not pay dividends, but which are expected to grow earnings or free cash flow rapidly in the future. NVIDIA is a good example of a growth stock. Other growth stocks do not even generate positive free cash flow today. They are expected to grow quickly at some point in the distant future, years from now.

Interest rates may be considered as the cost of waiting for those distant cash flows, which is why in the context of valuation they are referred to as “discount rates”. The further out the cash flow is expected to occur, the more interest-rate sensitive it becomes, and the less it is worth.

As rates shot higher in 2022, those future years’ flows were suddenly worth less. In 2022, growth-style company stocks sold off sharply, and discount rates popping higher was identified as the culprit by many analysts. The Russell 1000 Growth index fell by 29% last year.

Rates have continued to climb in 2023, perhaps not as violently as in 2022, but certainly rates remain elevated. Yet, the Russell 1000 Growth index was up 34% through the end of July this year. The narrative of higher interest rates spelling doom for growth stocks is not holding water.

Some of the reason for growth’s resurgence is the attention investors are paying to Artificial Intelligence (AI). It is too early to know the outcomes for AI and which firms will benefit from it, but that will not stop investors from trying to discern where future cash flows will grow.

The narrative has shifted in a completely different way for the other side of the stock market: value-style stocks. The most famous value stock is Warren Buffett’s Berkshire Hathaway, and big dividend payers such as AT&T exist in the value-sphere. Value stocks are expected to grow profits much slower, if at all, but those firms have less uncertainty for future profits, and they generate gobs of free cash flow today.

Thus, future profits from value names are often believed to be less interest rate sensitive. Value-stocks were off only 7% in 2022, a much better performance than the growth world, and the narrative was they held up due to their less rate-sensitive profile.

Many investors figured that value would continue to outperform growth in 2023 due to higher interest rates. Those investors have been wrong. The mega-dividend payers, who were lauded in 2022 for holding their own, have struggled mightily in 2023. Utilities stocks, acclaimed for their chunky dividend payouts, have taken it on the chin: the sector was down 11% through mid-August.

The reason cited by analysts for dividend payer struggles? Higher interest rates! Bespoke Investment Group wrote this week that as the Fed’s overnight target rate is now pushing 5.5%, and that the 10-year Treasury note yields 4.25%, dividend payers now face yield competition. The situation has crossed from TINA to TIAA - “There is No Alternative” to “There is An Alternative”. Those seeking income do not need to stray into equities at all.

The takeaway from these confusing, shifting narratives seems to be that while interest rates are important for stock market valuations and returns, they are not everything. Expectations for future free cash flow growth can swamp changes in the discount rate used to assign a present value to those cash flows. 

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