[The Editors' Verdict] Prepare for the Shift to a Performance-Driven Market

Joo Yushin, Dean of the Graduate School of Technology Management at Sogang University and Director of the Fintech Support Center.

The U.S. stock market has shown frequent declines since February, displaying a shaky outlook. So far this year, the Dow Jones Industrial Average has fallen 2.1% from its peak, and the Nasdaq has dropped 7.9%. Why have stock prices, which performed well even during the height of COVID-19, recently become so volatile?

While fatigue from a long-term rise is a factor, the key reason is the increase in interest rates. In early February, the U.S. 10-year Treasury yield hovered around 1.1?1.2%, but on the 25th, it surged to the 1.6% range, shocking the market.

Let's examine this through the dividend discount model. In this model, the fair stock price is calculated by discounting future dividends to their present value and summing them. Specifically, the dividends generated from future earnings in the numerator are discounted by the discount rate, i.e., the market interest rate, in the denominator. By closely analyzing the numerator and denominator, meaningful insights can be drawn. Dividends from earnings in the numerator reflect corporate performance, while the discount rate (market interest rate) in the denominator has an inverse relationship with financial market liquidity. In other words, when applied to the stock market, strong corporate earnings in the numerator indicate a performance-driven market, and a low discount rate (market interest rate) in the denominator indicates a liquidity-driven market.

Last year, the U.S. economy contracted by 3.5% due to COVID-19. The Federal Reserve (Fed) responded by declaring unlimited liquidity supply. Although the U.S. stock market saw good earnings from IT and digital companies, it is difficult to call it a broad performance-driven market. Ultimately, it is more appropriate to describe it as a liquidity-driven market based on unlimited liquidity supply characterized by ultra-low interest rates. Given that it was a liquidity-driven market, sensitivity to the key variable of rising interest rates is natural. Especially in tech stocks, which have many unrealized future earnings (dividends), the increase in discount rates is putting downward pressure on stock prices.

What lies ahead for the U.S. stock market? Experts emphasize that the nature of the interest rate increase is crucial. There are "good interest rate increases," which occur naturally as expected inflation rises with economic recovery and is reflected in higher rates, and "bad interest rate increases," where inflation or interest rates rise faster than economic recovery. Currently, the U.S. 10-year Treasury yield has fallen from its peak to 1.48%, and the consumer price inflation rate is 1.4%. The real interest rate has moved from negative to positive but remains near zero. This means it is not yet time to distinguish between good and bad interest rate increases.

However, Fed Chair Powell has stated that monetary easing will continue through 2023, and under the Biden administration, a massive economic stimulus package amounting to $1.9 trillion (approximately 2,128 trillion KRW), equivalent to 8.9% of U.S. GDP, is anticipated. The majority of the market views the current interest rate rise as a preemptive increase driven by expectations of economic recovery.

In the market, major investment banks like Goldman Sachs have revised their second-quarter U.S. growth forecasts upward from 10% to 11% year-over-year, and vaccine rollouts are proceeding faster than expected, boosting optimism about economic recovery. Considering this, the likelihood of a good interest rate increase seems higher than a bad one. However, because the liquidity-driven market characteristics have been so strong, there may be downward adjustment pressure as the liquidity phase ends, and investors should prepare for stock differentiation as the market transitions from liquidity-driven to performance-driven. In particular, for us, a U.S. economic recovery and rising interest rates are expected to strengthen the dollar, which could lead to capital outflows from emerging markets, including South Korea, so caution is warranted.

Jeong Yushin, Dean of the Graduate School of Technology Management at Sogang University and Director of the Fintech Support Center