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Advisors know that if clients are familiar with the concept of duration, it’s via its applications in the fixed income universe. That being duration measures a bond’s sensitivity to changes in interest rates. The longer the duration, the higher the sensitivity.
What many clients don’t know is that duration is also applicable in the world of equities. Yes, there are stocks that are considered long duration and others classified as short duration. Fortunately for advisors, the differences are easily conveyed to clients.
Companies with shorter duration stocks have more immediate cash flows – a favorable trait in today’s environment. Conversely, a longer duration equity is usually tied to a company with further out cash flows, many of which are growth firms, and that increases vulnerability as rates rise.
Not surprisingly, short duration equities have been the better bets over the past year. As such, now may be an appropriate time to reexamine the short duration equity thesis.
Revisiting Short Duration Equity Thesis
In the essence of making life easier on advisors and, in turn, their clients, here’s a valuable primer on short duration stocks from Charles Schwab.
What are short-duration stocks? Duration is the average time until cash flows are received, weighted by their present values,” according to Schwab. “In other words, stocks with more immediate cash flows have a shorter duration than those that are expected to deliver a higher proportion of cash flows in the more distant future. To measure duration for stocks we used the price-to-cashflow ratio, the lower the ratio, the shorter the duration. We define short-duration stocks in our charts as the lowest 20% of stocks in the MSCI World Index ranked by price-to-cashflow.”
One way of looking at that scenario is that as interest rates rise, many market participants favor companies with strong near-term cash flows. Conversely, when monetary policy is easy and rates are low, investors can indulge the risks associated with unprofitable companies and, in some cases, be rewarded for that risk.
Without the benefit of a crystal ball, advisors should prepare for the possibility of two scenarios emerging. First, a traditional global recession sets in, forcing the Fed and other major central banks to pare interest rates. That would benefit longer duration equities. Second, if severe economic contraction doesn’t come to pass, the Fed and its counterparts can likely hold rates steady, neither cutting nor raising. That would favor longer duration stocks.
Why Short Duration Stocks Could Stand Tall
As noted above, it’s a coin flip as to what economic scenario advisors will be dealing with as 2023 unfolds. However, coin flips aren’t useful for today’s asset allocation needs. The good news is that short duration stocks could be safe, valid bets over the medium-term.
“The global outlook remains uncertain–while growth and inflation are likely to moderate in coming months, how fast and how far is unknown,” adds Schwab. “Historically, after spiking higher, inflation has eased in wave like patterns–easing and rising again. Markets could remain volatile if inflation follows this wave pattern, which could result in higher-quality, short-duration stocks outperforming.”
The point: Short duration stocks don’t carry guarantees of upside, but the group might just offer advisors and clients much desired safety, relatively speaking, for the remainder of 2023.
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