“Preparing for a Paradigm Shift: Exploring the Impact of Rising Interest Rates on Growth Stocks”

Tech- and growth-oriented stocks have dominated markets for over a decade, but according to Steve Eisman, senior portfolio manager at Neuberger Berman Group, a “paradigm shift” is imminent as the Federal Reserve hikes interest rates to fight inflation. Eisman became famous for his successful bet against subprime mortgages in the run-up to the Great Financial Crisis (GFC) of 2008, illustrated in Michael Lewis’ 2010 book: “The great short film‘ and the film of the same name, in which a character resembling him was played by Steve Carell.

“Markets have long periods of paradigms in which certain groups lead,” the hedge fund said Bloomberg on an episode of the Odd Lots podcast on Monday. “Sometimes these paradigms change violently, and sometimes these paradigms change over time because people don’t give up their paradigms easily. And I think we may be going through that phase again.” Eisman pointed to Thomas Kuhn’s 1962 book The Structure of the Scientific Revolution as evidence that markets may be undergoing a gradual but volatile paradigm shift.

“For example, when Einstein came up with his theory of relativity… It’s not like everyone said, ‘Oh, we’ve been waiting for Einstein, thank God, now we can get rid of Newton.’ It took several years for people to realize that this was a better theory. I think that’s what happens in the markets,” he said. “Paradigms are so ingrained in people’s brains that sometimes they can’t even imagine there could be anything else.”

After years of tech stocks and cryptocurrencies soaring, said George Ball, chairman of Sanders Morris Harris, a Houston-based investment firm wealth in December that he expects another paradigm shift in the markets this year as investors adopt a more conservative stance.

“I think you see the occasional turning point in the investment and economic era, and we’re in one now after over a decade of near-zero interest rates,” he said. “Times of euphoria must be followed by times of abstinence.”

The old and the new

With the Federal Reserve keeping interest rates near zero for so many years after the Great Financial Crisis and during the COVID-19 pandemic, technology and growth stocks outperformed the broader market.

Low borrowing costs allowed these companies to easily invest in revenue growth, and a lack of viable alternatives to stocks due to low interest rates meant investors were “essentially being paid to take risks” and invest in them, Eisman said. In addition, according to the hedge fund, many investors suffered from the “Amazon disease”. By that he meant that the success of tech giants like Amazon — some of which were unprofitable for years before their stocks soared — has ushered in an era of speculative investing in growth-oriented stocks over the past decade.

“If you were a company from 2010 through early 2022 that had no earnings but strong sales growth, people dreamed the dream,” Eisman said, arguing that investors were always looking for the next Amazon, often ignoring fundamentals. But now that interest rates are rising, Eisman believes that revenue growth at many of these companies is slowing, ushering in a new era for investors.

He described how former stock market leaders have been overtaken during past market paradigm shifts like this one, noting that the financial stocks that outperformed before 2008 “have done literally nothing through 2020.”

“Let’s call it a dozen years that the old leadership group has disintegrated,” he said.

The hedge fund went on to argue that the rise of growth and technology stocks, which led the year earlier, is an example of how “people don’t give up paradigms easily.” The tech-heavy Nasdaq is up more than 13% year-to-date, and Cathie Wood’s ARK Innovation ETF — which focuses on tech and growth stocks and has become a guiding star for the sector during the pandemic — is up more than 37%. Eisman warned that this could be the “last hooray” for these stocks, but added that it depends on the Federal Reserve.

“[Federal Reserve Chair Jerome] Powell has said he’s going to keep raising rates, and the key phrase is, “and he’s going to leave them there.” If he leaves them there, I think we’re going to see a paradigm shift. If he cuts again, we’ll go back to where we were,” he explained. “I think he’s going to leave them there and we’re going to have a paradigm shift, but that’s not foreseeable at this point.”

This isn’t 2008…

While Michael Burry, another hedge fund driven by the success of “The great short film‘, arguing that stocks have been in the ‘biggest asset bubble of all time’ since 2021 and has predicted the ‘mother of all crashes’, Eisman doesn’t believe history is repeating itself. Improved regulation of the financial system has created a much safer system, he argues.

“I think 2000 and 2008 are like PTSD for some investors,” he said. “There aren’t many people on planet Earth who really understand how much the financial structure of the United States and Europe has really changed. So you see the markets crash and you’re like, ‘Oh my God, something bad is going to happen.’”

And while Burry has warned that a “protracted multi-year recession” is likely to loom, Eisman said he expects something much milder.

“Something bad could happen, you know, we could have a recession,” he said. “But I have a feeling we’re going to have an old-fashioned run-of-the-mill recession. We will not see a massive meltdown that completely compromises the system, as was the case in 2008.”

Learn how to navigate and build trust in your organization with The Trust Factor, a weekly newsletter exploring what leaders need to succeed. Login here.

Source: fortune.com