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.
This article has 29 comments:
They are worried about preservation of capital. Buying stocks during a recession probably doesn't rank high on the "preservation of capital" strategy list.
However, I will grant you that some folks will get frustrated with zero returns and move some money into stocks on every upturn but as soon as the market turns slightly against them, the fear factor will strike again and they'll flock back to treasuries which will exacerbate the stock declines.
I think that is a big reason you're seeing all the volatility now and it will likely be with us for some time...
The 1906 San Francisco Earthquake and fire, registered 8.25 on the Richter scale; estimates range from 700 to 3,000 dead or missing, approximately 225,000 injuries and $400,000,000 in 1906 dollars.
Recession, May 1907-June 1908, 13 mo
Model T, 1908, came into popular usage
Recession Jan. 1910-Jan. 1912, 24 months
Completion of the Panama Canal, 1914 – 27,500 workers are estimated to have died
Recession Jan. 1913-Dec. 1914 23 months
World War I -- 116,708 killed – 33 billion
Spanish influenza, 1918, killed over 500,000 people in the worst single U.S. epidemic.
Recession Aug. 1918-March 1919 7 months
The first radio news program was broadcast August 31, 1920, in Detroit, Michigan
Recession Jan. 1920-July 1921, 18 months
Recession May 1923-July 1924 14 months
Recession Oct. 1926-Nov. 1927 13 months
Bell Labs gave important demonstration of television April 7, 1927
The Great Mississippi Flood of 1927, flooded 27,000 square miles, 246 killed
The Great Depression, Black Tuesday, crop prices fell by 40 to 60 percent, after the panic of 1929, and during the first 10 months of 1930, 744 US banks failed. (In all, 9,000 banks failed during the 1930s). By 1933, depositors had lost $140 billion in deposits.
The Dirty Thirties, longest drought of 20th century. Peak periods were 1930, 1934, 1936, 1939, and 1940. The dust bowl covered 50 million acres in the south-central plains during the winter of 1935-1936.
Labor Day Hurricane of 1935, 400 killed
Recession May 1937-June 1938 13 months
World War II – 408,306 killed – 360 billion
Wartime Controls: 1941-1945 rationed consumer items ranging from sugar to gasoline
The United States developed the first atomic weapons during World War II
Recession Feb. 1945-Oct. 1945 8 months
The UN was founded in 1945 to replace the League of Nations
The Marshall Plan, July 1947 – 13 billion in economic and technical assistance were given to help the recovery of the European countries
Cable television, formerly known as Community Antenna Television or CATV, was born in the mountains of Pennsylvania in 1948.
Israel declares independence, May 14, 1948,
Berlin's Crisis (June 24, 1948 to May 11, 1949) was one of the first major crises of the new Cold War
Recession Nov. 1948-Oct. 1949 11 months
The Soviet Union tested its first nuclear weapon ("Joe-1") in 1949
Chiang Kai-shek moves his government from communist China to Taipei, Taiwan (formerly Formosa), where he formally resumed his duties as president on March 1, 1950.
Korean War, July 1951 - July 1953 – 33,000 killed in action
The United Kingdom tested its first nuclear weapon ("Hurricane") in 1952
Recession July 1953-May 1954 10 months
The Supreme Court rules on the landmark case Brown v. Board of Education of Topeka, Kans., unanimously agreeing that segregation in public schools is unconstitutional – May 17, 1954.
The Suez Crisis of 1956 – was a military attack on Egypt by Britain, France, and Israel beginning on 29 October 1956.
Recession Aug. 1957-April 1958 8 months
Alaska becomes 49th state of the U.S. on January 3, 1959
Hawaii becomes 50th state of the U.S. on August 21, 1959
U–2 Incident of 1960 occurred when an American U–2 spy plane was shot down over the Soviet Union
France tested its first nuclear weapon in 1960 ("Gerboise Bleue")
Recession April 1960-Feb. 1961 10 months
The Cold War, some estimates shows $8 trillion was spent, worldwide, on nuclear and other weapons between 1945 and 1996
The Cuban Missile Crisis, Oct. 1962
Martin Luther King is arrested and jailed during anti-segregation protests in Birmingham, Ala.; April 16, 1963.
Vietnam War, 1963 – 47,378 killed in action
200,000 people join the March on Washington. Congregating at the Lincoln Memorial, participants listen as Martin Luther King delivers his famous "I Have a Dream" speech. Aug 28, 1963.
The murder of JFK, 1963 Nov
Good Friday Earthquake (1964) In Alaska, it was the fourth biggest earthquake recorded
The Gulf of Tonkin Incident, Aug 1964
China tested its first nuclear weapon in 1964
President Johnson signs the Civil Rights Act of 1964.
Malcolm X, black nationalist and founder of the Organization of Afro-American Unity, is shot to death – Feb 21, 1965
1967 Arab-Israeli War – was fought between Israel and Arab neighbors Egypt, Jordan, and Syria. The nations of Iraq, Saudi Arabia, Kuwait and Algeria also contributed troops and arms to the Arab forces.
The murder of Dr King, April 1968 and Bobby Kennedy, June 1968
The city riots of April, 1968 – 30 cities affected
President Johnson signs the Civil Rights Act of 1968, prohibiting discrimination in the sale, rental, and financing of housing.
Hurricane Camille, Aug 1969, 259 killed
Recession Dec. 1969-Nov. 1970 11 months
Stagflation of the 1970s began
Nixon first imposed wage and price controls on August 15, 1971
World Trade Center ribbon cutting ceremony was on April 4, 1973
1973 Arab-Israeli War or Yom Kippur War – a surprise joint attack by Egypt and Syria on the Jewish holiday of Yom Kippur.
Oil Embargo, Oct 1973 long gas lines
Recession Nov. 1973-March 1975 16 months
Articles of Impeachment of Nixon started
(Approved by a vote of 27-11 by the House Judiciary Committee on Saturday, July 27, 1974.)
India's first nuclear test occurred on the 18th of May, 1974
Deregulation: 1974-1992 this era began when Nixon left office
Home computers start to enter retail markets, in 1977, and becoming common during the 1980s
Bell Labs launches first commercial cellular network in Chicago – 1978
Three Mile Island nuclear power plant crisis, March 1979
The Carter Administration decides to come to the aid of Chrysler Corp, 1979
Mount St. Helens eruption 1980
The US Savings and Loan crisis of the 1980s begins, more than 1,000 savings and loan institutions failed.
Recession Jan. 1980-July 1980 6 months
Prime reached unbelievable 20% in January 1981,
AIDS was first reported June 5, 1981 by the government – It is thought that more than one million people are living with HIV in the USA and that more than half a million have died after developing AIDS.
Recession July 1981-Nov. 1982 16 months
California earthquake 1983
The 87 market crash - Black Monday
Pakistan acquires the ability to carry out a nuclear explosion in 1987
California earthquake, 1989
Recession July 1990-March 1991 8 months
Iraq invaded Kuwait on August 2, 1990
Nikkei stock index crashed by over 30,000 points, the average home near Tokyo cost well over $2 million before the crash in 1989
The Persian Gulf War, 1991 or Desert Storm Jan 1991
Hurricane Andrew 1992 very destructive United States hurricane
World Trade Center bombing, February 26, 1993
The Great USA Flood of 1993
The 1995 bailout of Mexico
East Asian Financial Crisis was a period of financial crisis that gripped much of Asia beginning in the summer of (July) 1997
Intervention in the Former Yugoslavia – March 24-June 10, 1999, NATO bombing of FR Yugoslavia
The International Monetary Fund approves an immediate $5.3bil emergency payment for Brazil to rescue its economy, Dec 1998
IMF protects US banks in Russian bailout, July 1998, Russia receives $22.6 billion in loans
Dot Com Bubble, climaxed on March 10th, 2000 with the NASDAQ peaking at 5132.52
9/11 Attack, 2,974 people died
Recession March 2001-Nov. 2001 8 months, Airline Industry Collapsed
Enron bankruptcy in late 2001, employed 22,000
WorldCom, July 21, 2002, filed for Chapter 11
Iraq War, March 19, 2003 – 4,000 dead
Hurricane Katrina, late August 2005, 1,836 people lost their lives
Start of the Great Housing Recession/Depression or Sub-prime Recession, date to be determined
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.