Our New “Rate Cut” Signal Is A Positive for Tech Stocks

The real federal funds rate (interest rates minus CPI) recently turned positive. It should expand more by year’s end. That has historically preceded big rallies in technology stocks.

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If you want to generate better returns than institutional investors, then you need to know what they’re thinking… so you can stay one step (or two… or twenty) ahead.

Right now, big-money investors like BlackRock and Invesco are focused on one thing: the direction of interest rates. Rising or falling borrowing costs tell these institutional investors how aggressive they should be in their portfolio positioning.

When the Federal Reserve hikes rates, it’s aiming to slow inflation. In central bank-speak, that’s known as a “restrictive” policy level. By making borrowing more expensive, the demand for goods is reduced, which weighs on prices.

Until policymakers feel they’ve reached that restrictive point, rates will keep on rising. But once they think the federal funds rate is high enough, hikes can stop. And eventually, as inflation eases even more, they can start cutting rates once again.

The change in policy direction is key to our investing outlook.

As rates decline, borrowing money is cheaper. That means big investors can boost leverage and get better returns. In other words, they have more money to buy risk assets like technology stocks.

Last week we showed you that core Personal Consumption Expenditures (“PCE”) fell below the federal funds rate for the first time in five years, which has historically been a tailwind for stocks and bonds.

Today, we’re highlighting another important signal that tells us the interest rate outlook has changed. In addition to PCE, the Consumer Price Index (“CPI”) has also dropped below the fed funds rate.

This signal is additional confirmation that the Fed no longer needs to raise rates. In fact, looking further out, it may begin lowering them sooner than expected.

And that move should underpin a steady rally in the NASDAQ over the next two years.

Tech Stocks Have Been Clobbered

Last year was horrible for technology investors. In 2022, the NASDAQ Composite Index lost 33%. In fact, at the low point in late December, the index was down by as much as 35%... it was one of the index’s worst annual returns ever.

Why did tech stocks take such a big tumble? Three words: High interest rates.

Technology businesses – many of them, at least – rely on cheap capital. Creating new types of hardware and software, like iPhones and cloud computing, takes time and lots of money.

Often, there’s a lengthy period between developing and launching new tech – and (hopefully) generating revenues. And that means lots of debt in the meantime.

Borrowing isn’t an issue when interest rates are low. But when they’re going up, it’s a huge problem… because higher costs to service loans means it will be a longer road to profitability. And many tech companies don’t survive the transition.

Consequently, institutional investors penalize technology stocks in rising rate environments. That’s exactly what we saw last year.

Money managers either sold or shorted the group because they were unsure of where the Fed’s interest rate hike cycle was headed. Those sales left them underexposed to the tech sector, which gave them room to reinvest into tech stocks whenever the interest rate outlook improves.

And now, we’re seeing that outlook improve in real time…

The Interest Rate That Matters

To understand the Fed’s policy outlook, we need to understand the signals it follows. In particular, we want to follow the “real federal funds rate.” The central bank watches this gauge to understand when interest rates are restrictive. It’s derived by subtracting CPI growth from current interest rates. (You can read our explanation of the fed funds rate, and how it works, here.)

Following the release of April’s CPI, interest rates are back above inflation. Take a look…

As you can see, CPI growth fell to 4.9% for April. That compares to the effective fed funds rate of 5.1%. The change means real fed funds is positive once more…

As illustrated above, the current level is 0.2%. That’s important because real fed funds turning positive has been a precondition for ending past rate hike cycles.

Just look at the two lined up against one another to see how much of a leading indicator it is…

The last time the real fed funds turned positive was in November 2018. It peaked four months later in March 2019. That was just before the central bank started cutting rates.

And at the recent low in March 2022, it was -8.3%... right before the Fed’s current rate-hike cycle began.

Inflation’s Headed Lower – And The NASDAQ’s Headed Higher

Our next step is to model future CPI growth. That way, we can tell whether rate hikes have risen enough to keep weighing on inflation. Knowing that tells us if the Fed has room to start cutting rates once more.

And based on our forecast, there’s ample room to move lower…

The table above shows us what the bond market anticipates for future interest rates or “implied fed funds.” As you’ll notice, the current rate is 5.1%. But investors are expecting that by the time the central bank meets next January, they will have cut rates three times (by about 60 basis points) to 4.5%.

Then we estimate CPI to find the real fed funds potential.

Since 2000, month-over-month inflation growth has averaged 0.2%. We apply that rate to the nominal inflation index number of 303.4 for April to estimate numbers moving forward. After calculating results, we apply them to the same number from 12 months prior to figure out year-over-year (“YOY”) growth.

CPI could fall to 3.2% by January. In other words, even with 60 basis points of rate cuts, the real fed funds rate would still be 1.2%, a full point higher than where it is today.

And that will be a very positive indicator for tech stocks…

As we wrote earlier, falling interest rates will reduce borrowing costs. That will put money back into the pockets of tech companies. The change will mean Wall Street analysts need to revise earnings estimates higher. That will then drive multiples lower, improving valuations.

Think about it this way. If a stock trades at $10 and has $1 in earnings, its price-to-earnings multiple is 10 times earnings. But now, let’s say its debt-servicing costs have dropped. That has added $0.20 back to earnings, making the number $1.20. The change means the same $10 stock is trading at 8.3 times earnings. In other words, the valuation has grown cheaper, making the shares more attractive to investors.

To see how falling interest rates predict tech stock gains, we can look at the historical real fed funds rate compared to the NASDAQ Composite Index.

Notice the stock market tends to peak at about the same time the real fed funds bottoms. And then stocks crater as real fed funds start going back up.

But then, as we get toward the end of those cycles, and the consequent peak, stocks surge once more.

Look at the NASDAQ’s returns going back to 2000 for every time that the real fed funds rate has gone from negative to positive…

The table above tracks NASDAQ performance on a total return basis (dividends reinvested) from the end of the month in which real fed funds turned positive. Then, we tracked the data over three-, six, 12-, and 24-month periods. The average return is the sum of all those periods divided by the number of times it happened. The success rate is the percentage of instances where there have been positive market returns.

As you can see, real fed funds have gone from negative to positive five times since 2000. The typical return over the following year is 18%. As the success rate indicates, tech stocks have gained three out of those five times.

That’s far better than the NASDAQ’s lifetime average gain of 10.2% annually. The two-year average return is far better at 46% (23% annualized) and a positive return has happened each time.

That’s not a guarantee it will always happen, but it implies the odds are in your favor.

Here’s the same table laid out in a different visual for perspective…

Rate Cuts Rally Stocks

So, based on everything we’re seeing – the 500 basis points worth of increases to the fed funds rate since last March, combined with the direction of inflation growth – we expect the Fed to start cutting rates once more.

As we showed you, even with 60 basis points worth of cuts by the start of next year, the real fed funds rate will rise compared to where it sits today.

And if May saw the last rate hike for this cycle, look at what that means for tech stocks…

We laid out our table to track NASDAQ performance on a total return basis from the end of the month when the last rate hike was made. As you can see, stocks tend to take off after the rate hike cycle ends. The typical gain after one year is 10% and two years later that same number is 26% (13% annualized). Again, that’s better than the NASDAQ’s typical gain. You’ll also notice the likelihood of a positive result is very high.

Here’s that same table laid out in a chart highlighting the benefits of having a long-term time horizon…

As we said from the start, the best investors are typically forward thinking. They’re not looking at where the market has been, but are anticipating where it’s headed. They’re trying to invest in what the economic and stock market outlooks will be in eight to 12 months.

Based on what we’re seeing, the Fed’s rate-hike cycle should be ending. And once that realization has set in, those big institutional investors will anticipate that rate cuts aren’t too far behind. When rates start falling, that means borrowing costs drop once more.

Cheaper access to funds boosts the outlook for tech companies’ profits and cash levels. They won’t have to spend as much on servicing debt. The rise in margins will drive price-to-earnings multiples lower. In other words, the group will become more attractive to investors everywhere from a valuation standpoint.

And as the roadmap begins to unfold, it will encourage fund managers to lever back up and buy more tech stocks.

How to Safely Invest in Tech

If you’re interested in investing in this scenario, we’d recommend looking at the Invesco NASDAQ 100 Trust (QQQ).

The fund tracks the performance of the NASDAQ 100 Index. It invests in all the member companies – including behemoths like Microsoft, Apple, and Amazon – weighting them by market capitalization. It typically trades around 57 million shares per day. So, it’s easy to get into and out of.

Investors should note that the “basket” strategy limits upside participation in the huge rallies experienced by individual companies’ shares during a bull market. But diversification can spare them downside pain during a bear market selloff.

Scott Garliss

Porter & Co.
Stevenson, MD

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