Bonds might spoil the party
Priced for Perfection
One of the less fun aspects of my job is to continuously monitor risks to our portfolio. While it’s definitely more interesting to dig into new names and themes when your portfolio is up 57% YTD, you also have to consider what might spoil the party for us.
Bonds might just be that.
So, with the AI trade in full swing and investors more than willing to pay, check notes, 100x revenue multiple on a loss-making company, it’s important to take a step back and evaluate what will happen if (when?) the Fed starts raising interest rates.
Interest rates are important once more
What most investors conveniently forget in a hype cycle is that a stock’s value is ultimately what the company will earn in the future, discounted back to today. So, when you are buying a company with a P/E of 50, it means that, based on current earnings, it will take 50 years for the company to “pay back” your investment.
You could argue that the 50 P/E company is growing rapidly, and your payout will be much faster. But the fact remains that most of your return is coming from projected cash flows that are 10+ years out.
Coming back to the interest rate bit, the moment rates rise, future earnings are worth less in today’s dollars. A company whose value is predominantly based on future profits will immediately get re-rated.
That’s what happened in 2022 once the Fed started raising rates:
In many cases, the company fundamentals actually improved — Shopify nearly doubled its revenue from $2.9B in 2020 to $5.6B in 2022, yet the stock fell ~70% because of multiple compression. In 2020, the company traded at a 50x revenue multiple, compared with an 8x multiple in 2022.
Same company, different interest rate environment.
Now look at where Semiconductor stocks are trading now:
We are in the best market for semiconductor stocks in the last few decades, and that has driven valuations too far for some companies. So even if the growth projections actually come through, if the Fed starts raising rates, all these companies will get re-rated.
What are the odds of a rate hike?
According to the CME FedWatch Tool, there’s a 70% chance of the Fed raising the federal funds rate by the end of the year. The heaviest odds (more than 40%) are on the Fed doing one quarter-point rate hike from the current target of 3.50%-3.75%. The good part is that there is only a 2% chance of a rate hike in the next FOMC meeting (Mid June).
The real worry is not the 25bps hike: it’s a combination of a new hawkish Fed chair, sticky inflation (due to tariffs and Iran war), and rising national debt — all hitting simultaneously when the semiconductor names are priced for perfection.