For equity traders accustomed to cutting-edge technology stocks always outperforming the broader indices, the last couple weeks have been an eye-opening reminder of the concept of “market rotation.” Essentially, market rotation refers to the shift between different types of stocks leading in the market; to state a point that should be obvious, but that many have forgotten over the last decade, a strong business or industry doesn’t always lead to strong stock performance. In many cases, the shares of strong businesses in strong industries get so expensive that they’re essentially “priced for perfection” and any negative or even neutral developments can lead to a dramatic selloff.
That’s exactly what we’ve seen over the past month in previously white-hot momentum ETFs and stocks like the Tesla Inc (NASDAQ:TSLA), Nio Inc Class A ADR (NYSE:NIO), Zoom Video Communications Inc (NASDAQ:ZM), and Teladoc Inc (NYSE:TDOC). These previous high-flyers have been absolutely clobbered this week, with the recent surge in interest rates prompting investors to reevaluate the appeal of these fast-growing, but low-profit firms.
Why do high interest rates hit fast-growing, low-profit firms hardest?
Finance 101 tells us that the value of any asset is equal to its future cash flows, discounted back to the present at an appropriate rate. In other words, when the discount rate is near zero, there’s little difference between profits earned today and profits expected to be earned in a decade. While firms like Tesla Motors and Zoom Video aren’t particularly profitable at the moment, investors have been betting that they’ll be far more profitable in the future, and with interest rates near 0%, those future profits may be nearly as valuable as those of a more profitable but slower growing company today.
Combined with that technical explanation, the underlying businesses are particularly reliant on their share prices rising, which allows them to attract top talent with offers of stock options and the ability to raise capital cheaply by issuing more shares. If this virtuous cycle comes to an end, they’re likely to see a simultaneous exodus of talent and a rising cost of capital, creating a self-fulfilling prophecy where future growth falls.
As the chart below shows, each of the stocks highlighted above have seen drawdowns ranging -40% to -50%, in most cases over the past couple weeks alone:
So what’s next for these momentum stocks?
There’s certainly more to the story than just one variable, but the path of interest rates over the next couple of weeks will be a big factor in determining whether stocks like TSLA, NIO, ZM, and TDOC are able to recapture their previous bullish momentum. With each of these names seeing their biggest declines since last year’s COVID-driven collapses, we’re skeptical they’ll regain their bullish mojo any time soon, so traders may want to look for selling opportunities on any short-term bounces.