Since bill prices are used as the input into other pricing models (most notably the Black-Scholes option pricing model), the distortions in the [Treasury] market have the potential to feed into other markets (we've already seen problems with new issue bond pricing due to sharp increases in spreads and blow-ups of correlation models in the credit default swaps market).
The word "model" conjures fancy, expensive things tended to by rocket scientists. But for "value" oriented stock investors, simple discounted cash flow valuation still occupies a place of honor. DCF valuation models require two inputs: an expected stream of cash flows (projected dividends, free-cash-flow-to-equity, whatever) and a required rate of return.
One of the lovely aspects of fundamental stock valuation is that it lacks hubris. Everyone knows that stock prices fluctuate unpredictably, so trying to estimate anything to twelve decimal places is just dumb. Value investors look to get a ballpark estimate of a stock's worth, and buy only if there's a large margin of safety. If you have to call in the quants, it ain't worth the risk. The required rate of return is often chosen in the simplest way you can imagine: Check the Wall Street Journal for a current Treasury yield, and call that the "risk-free rate". Ask yourself how much more you'd need to earn for it to be worth your while to hold the stock, and call that a "risk premium". Add the two together, and voila! You've got a required return by which to value the shares.
One of the channels by which Fed interest rate cuts affect the economy is to boost stock prices by reducing the "risk free rate", and therefore investors' required rate of return. But terror and turmoil in credit markets has goosed demand for safe Treasuries, driving yields well below what the Fed would expect given its current rate stance. In January of 2005, the Federal Funds rate was targeted at 2.25%, same as now, and a 3-month T-bill paid 2.21%.
Today, we have the same Federal Funds rate, but the 3-month T-bill yields 0.34%. The 5-year Treasury paid 3.61% in Jan 2005. Today the rate is 2.37%. On any of the common proxies for a risk-free rate, flight to safety in the credit market has introduced a rate cut of between roughly 120 and 190 basis points beyond what Bernanke & Co would have expected based on the 2005 experience. If the marginal value investor hasn't increased the premium she demands for holding equities by the same amount, then all the gnashing of teeth about a financial meltdown may actually be net supportive of equity values!
Now this is weird, since equity is supposed to be the high risk, first-loss side of investment universe. But a recurring theme in the current crisis is that whatever you always thought was safe is not safe. The familiar risks of stock investing might seem like a warm campfire compared to the blizzard of uncertainty on the fixed-income side. It's not obvious that investors would demand an unusually high premium for holding equities right now.
The Fed is working hard to restore some semblance of normalcy to Treasury markets. It would be ironic if that were to inadvertantly remove an important prop from beneath stock prices. If there's anything to our little valuation speculation (it is only speculation!), the Fed may wish to mingle some rate cutting with its efforts to satisfy market demand for Treasuries, in order to hold roughly constant the effective risk-free-rate for equity valuation.
I wonder why?
You are short and want to see 8000 on the S&P.
You actually thought I wanted you to make a one hundred year investment.
You have positions in gold, US treasuries, and oil that is juxtaposed to the dollar.
How someone can have zero faith in the US government and still buy US backed treasuries is puzzling. The US government stands by her US treasuries.
The vulgar comments don’t help your argument and proves nothing except that a nerve has been struck and/or there is some prevailing weakness in your investment strategy and you needed to lash out.
I find it ironic that in all the vulgar comments, none were about the history that was listed. Perhaps some of you lost money last week? I do not take solace in this.
The time period for the history was a little over a hundred years. Some of you, with today’s technology and medicine may very well live to be over a hundred years old. If you think about it in those terms it shows that a hundred years is really not that long a period of time.
I take no pride in seeing anyone lose money. I will let history speak for its self.
Can you please give me some real data? You are just making general statements that are subjective. For example, what do you think of the Marshall Plan? Did it work? Why or why not? Give me the details?
As I mentioned above, I hit a nerve and this caused a reaction and in some cases the reaction was vulgarity. So you said: “Tony, Tony, Tony - you are full of pith.”
So you said: “your listing of historical events is like saying "the sky is blue”.
I just listed the events with no interpretations. However, your interpretation, the sky is blue, is very interesting. To me, you are indirectly saying the historical events are positive (bullish).
tony s., mommy just called you, it's time to change your diaper.
You have made no counter argument?
You are just making general statements that are subjective.
I will let the historical facts speak for themselves.
Don't misread the low yield of treasuries--it is a false reading.
Demand for treasuries is higher than it would be otherwise if it weren't for: 1) Chinese need to recycle dollars 2) Fed desire to prop up economy 3) Scared money seeking "safe haven" during recession,and credit crisis, and 4) the underreporting of inflation, that makes investors miscalculate the risks of holding bonds.
Investors fight the last war, and position themselves for the known and the obvious risks, while avoiding the less obvious risks. The last FINACIAL war was was the Japanese deflation of the 90's--that Bernanke and company are sworn to not repeat.
With massive debt bubble, and the tsunami of dollars being created to re-inflate, the more likely outcome is a stagflationary 70's.
Oil may fall to 80, gold to 750, silver to 12, but these will be cyclical selloffs in an overall upward trend. Those who don't understand commodity investing say that it is "risky".
Some of those same folks say that bonds and fixed income are far less risky. But, in an upward inflationary trend--bonds get killed and commodities outperform.
Finally, There is no such thing as a risk free investment.
All investments must beat the long term rate of inflation if one is to prevent a real loss of capital. Buying a t-bill that yields .58% and holding for a year representS the guaranteed loss of between 3-5% (or more ) of capital.
Why not buy ConocoPhilips ( Disclosure: I own COP) at a forward 6 PE, a yield of 2.2%, and a natural hedge against inflation?
The stock may drop in the short term, but ten years from now you will double, triple, or quadruple your investment, and collect that rising dividend--something that a bond cannot match.
During the cold war we had a doomsday clock!
It showed how many minutes we had left till total destruction.