Why are technology companies hit by rising interest rates?
Another reason why the Fed insists on a low overall impact on equities from rising interest rates, and which has been vindicated lately per our chart above, is due to the concept of equity risk premium. This is the key to understand why bubble stocks have been hit hard by rising interest rates.
The equity risk premium on US equities is currently estimated to be 4.6% by finance professor Aswath Damodaran, which is the leading expert on equity risk premium and equity valuations, which is close to the lowest level since the Great Financial Crisis. The US equity risk premium has been stable over the past 10 years with an average of 5.6% and a standard deviation of 0.7%. This takes us to the next concept of cost of capital which is essentially the weighted average of cost of equity and cost of capital.
Cost of equity is essentially the risk-free rate (US 10-year) plus the equity risk premium expected by investors. The S&P 500 has currently short-term and long-term debt of 1,152 per share which means that the average S&P 500 company has a debt ratio of 23% in the cost of capital equation. Using the yield-to-maturity on US investment grade corporate bonds of 2.35%, we can calculate the cost of capital for S&P 500 as (1.55% + 4.63%) x 77% + 2.35% x 23% = 5.28%. Of this cost of capital the risk-free rate is only a 30% component – a 100 basis point move higher from current levels, assuming constant credit spread and unchanged equity risk premium, would increase cost of capital to 6.28% or a factor of 0.19 increase in the discount rate.
If we look at the bubble stocks, then we are suddenly talking about companies where the equity side is 98% of total cost of capital. What makes it worse is that they are all aggressively valued with implied equity risk premiums in the range -2% to +1%. This means that the risk-free rate suddenly dominates the cost of equity and since the equity weight is close to 98% in many of these names the entire segment is very sensitive to rising interest rates unlike the overall equity market.