As the Federal Reserve has aggressively raised interest rates over the last year to fight inflation, shorter-duration bonds have offered higher yields than their longer-duration counterparts.
Surprisingly, a similar dynamic has existed for equities, according to financial services giant, Schwab. Short-duration stocks, meaning those that produce cash flows in the near term, have outperformed the broader market for several years now. But with interest rates potentially peaking, are short-duration stocks no longer viable? Not so fast, says Schwab.
Consider working with a financial advisor if you need help selecting investments and managing your portfolio.
Short Duration vs. Long Duration
As Schwab explains in a recently published commentary, a stock’s duration is the average amount of time it takes to produce cash flow. Long-duration equities are stocks that are expected to produce their highest cash flows in the future. These companies are often growth-oriented and, like long-duration bonds, are more sensitive to interest rate hikes and inflation than their shorter-duration counterparts.
Short-duration stocks, on the other hand, generate more immediate value and have lower price-to-cash flow ratios. They may not provide the same upside potential as a long-duration growth stock, but these companies are often more cash-efficient and better equipped for high-interest rate environments.
“Since interest rates began to climb in August 2020, investors have favored companies with stronger near-term cash flows,” Jeffrey Kleintrop, a chartered financial analyst (CFA) and Schwab’s chief global investment strategist wrote recently. “This was the opposite of the investing cycle of 2009-2020 when companies with little to no earnings or cash flow were the among the best performers, due to abundant low-cost funding.”
Short Duration Stocks Have Outperformed
Over the last year, short-duration stocks have outperformed the broader market by 7%, Schwab found. However, that trend goes back even further.
From August 2020 through the end of 2022, the 20% of stocks with the lowest price-to-cash flow ratios in the MSCI World Index outperformed the total index 55.1% to 18.4%. MSCI World Index tracks over 1,500 large- and mid-cap companies across 23 developed markets.
In 2022, when the MSCI World Index fell by 17.8%, the short-duration stocks were mostly flat (+0.4%). While short-duration outperformance has continued in 2023, it was briefly interrupted by the collapse of Silicon Valley Bank and Signature Bank in March. The banking turmoil unleashed widespread uncertainty of how central banks around the world would respond. If they suddenly lowered rates to calm financial markets, short-duration equities would potentially suffer.
But the Federal Reserve instead opted to raise the federal funds rate 25 basis points at its most recent rate hike meeting. In fact, short-duration stocks have continued to outperform the wider market since March 17.
Will Short-Duration Stocks Stay Hot?
Whether these trends continue largely depends on the interest rate environment. “Should interest rates take a dive in response to a deeper global recession where central banks are forced to cut rates aggressively back toward zero, we may return to an environment of cheap capital that could power outperformance of long-duration stocks,” Kleintrop wrote.
But Kleintrop noted that no central banks have indicated they would cut rates this year, suggesting the environment will remain favorable for short-duration equities.
Then again, the performance of these stocks hasn’t just been attributed to high-interest rates.
“These companies, with their higher cash assets, tend to have relatively strong balance sheets, solid interest coverage ratios and low default risk,” he wrote. “That helps to make them attractive during periods when access to capital becomes more difficult and earnings growth is shrinking.”
Bottom Line
Stocks that produce near-term cash flows instead of long-term growth have outperformed the broader market since August 2020, according to Schwab. While short-term bonds have benefited from recent rate hikes, so too have these short-duration stocks. Schwab’s view is that interest rates likely won’t fall suddenly, and instead, will remain elevated this year. That should allow short-duration stocks to continue to outpace the broader market.
Tips for Managing Your Portfolio
- A financial advisor can build your portfolio of stocks, bonds and other assets tailored to your investment goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You may look to cut your losses and cash out your investments when the stock market is in free fall, but market timing is all but impossible. Not only do you have to accurately time your exit, but you also have to know the right moment to reenter the market. That’s because most of the stock market’s strongest days occur shortly after its worst days. The majority of investors are better off assuming a long-term outlook and staying invested through periods of volatility.
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