Stocks fell hard at the start of 2022 for two good reasons. The first was inflation, which was worsening and seemed to be stuck at a high level for months if not longer. On top of that, you had a Federal Reserve that was compelled to increase interest rates, and who had made it clear they would do exactly that throughout the year. Yet stocks ripped upwards when the Fed finally did raise rates on Wednesday, March 17—the Nasdaq 100 (QQQ) went up by a staggering 3.7%, one of its best days in history.
There are several explanations for this, but they all stem from the same core concept, which is a very fundamental and important one: TVM. If you have taken any finance classes, you are familiar with this acronym; it refers to the time value of money, and it is a core concept in finance—one that cannot be shaken and, arguably, is the most important ideas in all of finance.
The idea is simple: would you rather have $100 today or $100 in a year? Obviously you’d take the former, but what if I offered $101 in a year? $105? Or $110? Thus we see there is a value to waiting a year to get that $100—that is the time value of money, and it varies from time to time and person to person.
There are several ways that TVM is used in basic financial analysis, but it is also a core component of the stock market. Remember that stocks are slices of ownership in companies, and their value is directly connected to the cash flows those companies produce. Higher cash flows mean higher stock prices, but lower cash flows that flow faster can also mean higher stock prices.
This gets us to the first component of why stocks ripped upwards: the Fed’s 25 basis point interest rate was clearly signaled, so it was the baseline expectation. But the Fed had also hinted that a 50 basis point hike was possible in March, and by reducing that it effectively meant that, while cash flows would be lower than pre-rate hike, they would flow faster than if a 50 basis point hike had come. Thus stocks soared.
This isn’t the only way that TVM mattered with stocks’ very good day. Another facet of TVM is that a stock is, as a claim of ownership on future cash flows, valued relative to future cash flows. The past simply doesn’t matter—not directly. If a company has 100 shares and earnings of $100 and a P/E ratio of 3, its shares are worth $3 each. If the company suddenly releases a new product that produces earnings of $1,000, its $100 earnings of the past no longer matter; all else being equal, the shares will now rise to $30. And probably more, as there is the implication of higher growth further in the future.
Throughout the early part of 2022, traders were speculating on what higher interest rates would do to cash flows, and as a result the market was finding a new valuation that made sense with the interest rate hikes. But as soon as the hikes began, the baseline valuation had found a new floor—this is what we mean when we say the stock market doesn’t like uncertainty. Uncertainty means you have to expect a very wide range of possible cash flows, and some of those are really bad. When a factor is certain, you no longer have to price in that scenario and it can hike the value of your stocks.
This is one reason why stocks tend to go up immediately after a piece of feared bad news becomes public. The “feared” is crucial here. Black swan events—things no one was expecting or that people had considered unlikely (like a global pandemic or a war in Europe) will make stocks tumble when they first come about. But bad news that the market has had time to consider will already be priced in—the market has had time to assess its weight on values and price accordingly.
The stock market rally immediately after the Fed’s announcement isn’t the only piece of evidence towards this aspect of stock market behavior. Actual trading in the minutes before the Fed’s announcement were wildly volatile—stocks actually briefly went red before soaring over 2% in an hour and a half. Those minutes of volatility were the last moment of panicked repricing of the 50 basis point risk before the risk disappeared. Understanding these dynamics in markets are simple if you understand stocks not just as a claim of ownership on cash flows, but a claim of ownership of cash flows that can change over time—and those changes in timing have a price.