Here's what you would think would happen when interest rates drop

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Here's what you would think would happen when interest rates drop

Higher interest rates threaten the so-called FAAMG stocks. I m referring to Facebook FB, Apple AAPL, Amazon.com AMZN, Microsoft MSFT, and Google Alphabet GOOGL, whose combined market caps now represent a quarter of the S&P 500 s SPX, total. The source of this growth in valuation has been largely unknown — until now.

Recent research shows that declining interest rates are helping to fuel these companies higher valuations. Rising rates, therefore, could cause these mega-cap stocks to lose market value.

This conclusion is just the opposite of what you would otherwise suspect. You d think that higher interest rates would disproportionately hurt smaller companies and those that are barely surviving, so lower rates would help them more. The study s authors are Thomas Koren, Ernest Liu and Atif Mian of Princeton University and Amir Sufi of the University of Chicago. The National Bureau of Economic Research began circulating the research earlier this week.

The researchers reached their conclusion after constructing two hypothetical portfolios. The first, the Leaders portfolio, was constructed to contain the stocks of only those firms that were in the largest 5% of companies in an industry. The second, the Followers portfolio, contained all others. The relative performances of these two portfolios between 1962 and 2019 were then correlated with changes in the 10 year U.S. Treasury TMUBMUSD 10 Y, yield.

The researchers found that when the 10 year yield declined, the Followers portfolio outperformed Leaders portfolio. This performance advantage widened at an accelerated pace when U.S. interest rates were particularly low.

Consider how much faster the leaders market caps would be expected to grow if the 10 year yield declined to 1.0% from 2.0%. Based on data from 1962 to 2019, the researchers estimate that this rate decrease would result in a 5.3 percentage point increase in the market valuation of the Leaders portfolio relative to the Followers portfolio.

No wonder that the largest companies in recent years have to come to represent an ever-larger share of the overall stock market. From the turn of the century to its low last year, the U.S. 10-year yield fell to 0.5% from 6.5%.

When interest rates rise, just the reverse can be expected. That s why the FAAMG stocks are now at risk of losing market share; the 10-year yield has been rising to 1.6% currently from 1.2% last August.

In an interview, Sufi identified two major reasons:

Lower rates reduce the borrowing costs of the Leaders more than for the Followers, and the Leaders take advantage of it. When rates fall, they borrow more money and their leverage increases. The Leaders in turn make more capital expenditures relative to the Followers, undertake more cash acquisitions and invest in more property, plants and equipment.

Lower rates reduce competition, according to the researchers, because they induce the Leaders to become competitive. That s because their present earnings become more valuable in future value terms as interest rates decline, leading them to go for the kill in their competition against their rivals. Companies that previously were able to hold their own against the Leaders now find it much harder to keep up.

For investors, the study suggests that the largest stocks will struggle when interest rates are rising.

The policy implications trace to the anti-competitive consequences of low rates. The new research suggests that low rates may actually not be contractionary, as is often assumed, but expansionary. That s because they are anti-competitive, leading to low concentration and possibly weak investment and increased productivity growth.

Mark Hulbert is a regular contributor to MarketWatch. He can be reached at mark hulbertratings.com.

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