Nov 10, 2022

Hurdle Rate Remains 10%

Hurdle Rate: what you must clear on a risk-adjusted basis for it to make sense to buy something other than treasuries.

While the equity markets and "shitcos" get giddy about today's CPI print coming in beneath expectations at 7.7% year over year it will behoove everyone to remember that the terminal US fed funds rate is still expected to be between 4-5%.

This 4.5-5.5% is the "risk-free rate" i.e. the least risky way to get a return on money. Meaning that you can buy government bonds risk free--the US isn't going to default on it's debt--and receive 5% per year. So if you are a money manager hunting for returns above that risk-free rate you must clear it on a risk-adjusted basis for it to make sense to not just take the risk-free rate.

In equities, and certainly in growth companies with negative earnings, the risk-adjusted return is going to be at least double the risk free rate. Probably closer to 12%.

In essence, to "beat the market" you need to return 12% per year if government bonds return 5%. 12% is non-trivial in good conditions. 12% is difficult in a rising rates environment. 12% is even more difficult if you're a company losing money in a rising rates environment.

So while it feels like a party today with companies like AFRM and CVNA up 25-30%, it's hard to imagine it lasting because the overnight rate--which determines the risk free rate--as stated by JPowell, will remain higher for longer.

The longer it remains high, the longer that hurdle rate remains high.

This kind of math is what drives institutional money. As a major money manager where are you putting your money if inflation stagnates between 4-5% and the risk free rate is 5%? BNPL companies making loans to people to buy Jordan's or 10y treasuries?

Don't let the economy surprise you.

Economic releases, key earnings, speeches, weather, and other market moving events for the week ahead are highlighted in our weekly Sunday note.


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