Could flight to safety in credits help boost equity prices?

Treasury securities are trading at bizarrely low yields, and Yves Smith offers an intriguing thought:

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.


15 Responses to “Could flight to safety in credits help boost equity prices?”

  1. I reject the concept of a “risk-free” rate, even though I was exposed to it at the “House of Fama-Miller”, i.e., the University of Chicago. There may be a “least risky asset”, but no riskless asset. The least risky asset, GOLD! When foreigners throw in the towel on the dollar, Americans will discover they thought they were holding the riskless asset, but only believed it because the dollar is our numeraire. Foreigners think differently.

  2. groucho writes:

    Steve, you’ve “struck gold” again. Do you have a clear picture of who’s been purchasing treasuries?(domestic or foreign)

    It looks like a continuation of Greenspan’s conundrum, where the spreads move opposite to the FED’s FRBUS model.

    BTW, Richard Duncan spelled out years ago how the trade imbalances distort int capital flows causing bubbles all over the world in his extraordinary book “the dollar crisis”.

    Using Duncan’s theory has made it quite easy for me to watch the global economy evolve, with very few surprises.

  3. groucho writes:

    “Could flight to safety in credits help boost equity prices?”

    Steve, absolutly…as the “conudrum” was to housing/structed finance, the current low yield environment will drive solvent investors into perceived “relative value”….Hi Ho, Hi Ho, back to equities we shall go.

    Ain’t runnin’ an asset bubble finance economy fun!! Now where’s the relative value in equities? Hint, what does the US need? Running out of cheap energy and the coming baby bust should be the chief demand drivers.(hopefully, the US will give up it’s world’s policeman role…can’t afford it)

  4. nikoulis writes:

    But that’s exactly the point: The Fed attempts to support the stock market by lowering short-term (and therefore, hopefully, long-term) interest rates, which makes stocks more attractive, everything else being equal. However, the recent turmoil has increased risk premiums across asset classes, so lower Treasury rates don’t necessarily help all that much. Also, the process is not static: As stocks become more attractive because of lower Treasury rates, money flows into the stock market and away from the Treasury market, which raises Treasury rates and makes stocks less attractive on a DCF valuation basis.

  5. Fullcarry writes:

    I just wanted to note that quarter end in the US and year end in Japan are seasonal factors that have a big influence on bill rates. Bill rates should ease up somehat after 3/31.

    Also with so many countries defending their pegs to the US dollar, demand for nominally risk free assets is much larger than historically. So the signals that these markets might be sending could be skewed.

  6. sk writes:

    A couple of things :

    1. The assumption is that the increase in risk premium required by equity investors is the same or less then the decline in nominal risk free rates has to hold for this to be true. Is there data to back that ? My feeling is that as a class as a whole ( not just value investors ) equity bulls in these turbulent times would have risk premiums approaching infinity ( worries about return OF capital not ON capital ). As a corollary, equity bears, who never seem to factor in these models, have risk premiums approaching zero ( not -infinity).

    I use “feeling” quite deliberately.

    2. Aren’t these short term moves ? The behavior of the value investor has to be some average over some duration, durations measured in several years – we already have, if the Fed is to be believed( those dreaded “feeling”, “believe” words again) statements of a willingness to raise interest rates just as actively once this is all over. So, what’s the expected short term interest rate over the next 2 years say – if its over ? And if its NOT over, then what’s the risk premium requirement if its NOT over ? And what’s the optimal expectation ?

    I have no freakin’ idea – hence my use of the words “feeling”.



  7. capekeeper1 writes:

    In a standard dividend discount model an investor generally attempts to do two things: first, produce an annual forecast of the risk adjusted free cash flow that a firm will generate over a finite — say three to five year period; second, calculate a terminal value for the firm, which is typically done by discounting a stream of cash flows to infinity. Typically, under this approach, 80-90%+ of the total firm value is comprised of the terminal value.

    Implicit within this approach is the assumption that the firm under consideration will exist into perpetuity — stated differently, most DCF analyses assume that the probability of bankruptcy is ZERO. In addition, given this assumption, one typically would not use a short or medium term (3 month to five year) interest rate as the basis for one’s risk-free rate — rather the cash flows generated by presumably long-lived assets should be discounted by an appropriate long term (10-30 year) interest rate.

    You state that “It’s not obvious that investors would demand an unusually high premium for holding equities right now.” It depends on the equity under consideration — a rational investor would not apply the same discount rate to the future cash flows of Coke, Pepsi, and Lehman Brothers. The key point is that, as the probability of bankruptcy rises — an event whose probability most dividend discount models assume to be zero — the ability of a dividend discount model to yield reliable results is greatly diminished.

    Let us briefly consider the last week — how does one neatly fit what happened at Bear Stearns — the stock was worth $30 last Friday evening and is now worth $5.96 and appears headed to $2 — into a DCF framework? Alternatively, consider Lehman, which was worth $20 intra-day on Monday and is now worth almost $49. Perceptions about the relative solvency of these firms is what obviously produced the dramatic swings in their share prices. In short, I believe that using a DCF framework to value corporations where the probability of bankruptcy is fairly high is a sub-optimal approach. To illustrate this point, go back and calculate, using the capital asset pricing model, what the required return on Bear Stearns was on March 10. Does seem like a reasonable number given the liquidity concerns that had begun to emerge?

    Finally, you state that “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.” I am not sure that I agree with this premise. There are two key points. First, Bernanke’s great concern, in my view, is deflation. The Fed’s recent actions have been designed to prop up large investment and commercial banks whose balance sheets are, shall we say, in a delicate state. If these firms were allowed to fail, the resulting contraction in credit could trigger a deflationary spiral in the US. This is how I believe the Fed sees it.

    Second, given this, what are investors to make of 3-month yields of 60 basis points and a 1.59% yield on the 2-yr note? There are at least two possible interpretations. The optimistic view is that investors are hiding in these safe havens until the storm passes. The bearish view is that the deflation genie is already out of the bottle — far-sighted bond investors, sensing a deflationary period for the domestic economy lies just over the horizon, have adjusted interest rates accordingly. Meanwhile the Fed is hoping for the former but is terrified of the latter — hence its frantic desire to reflate by slashing rates and destroying the dollar.

    The important point, vis a vis Steve’s article, is that IF — this is a big if — the Fed succeeds in restoring “some semblance of normalcy” to credit markets generally, then eventually banks will be able to begin to reliquify their balance sheets, credit will once again begin to flow, economic activity will accelerate, solvency concerns will abate, and we will be treated to the spectacle of rising interest rates and rising equity prices (reason: investors flee the safe haven of treasuries and pile into stocks whose earnings prospects improve as economic growth picks up). At which point we will be able to dust off our dividend discount models and begin to search for the next bubble.

    Finally, Steve, I love the site and the work you’re doing. keep it coming!

  8. jh writes:

    The academic models have never dealt directly with the issue of interest rate risk on the “risk-free rate”. Equivalently, they have never dealt with the issue of time horizon for the risk free rate. In this sense, the “risk-free rate” is instantaneously risky along the interest rate risk dimension for any time horizon. Any modeler who doesn’t understand this is a fool. This present t-bill aberration is only one example of the problem. Those who simplistically resort to the “Fed model” for valuing equities (comparing the earnings yield with the 10 year yield) must also consider this. And so on.

  9. PrintFaster writes:

    Perversely, I am looking at the 30/FFR spread and seeing the flight to short term treasuries as an inflation fear. Notice that the TIPs went negative last week.

    The only way such an unbalanced mad rush to the short end is panic fear that inflation is about to go crazy.

    Another reason to expect the stock market to go up.

  10. To me Fed interest rate reductions boost stock prices for a different reason, disagreeing with Yves Smith. Frederich von Hayek introduced the competiton in currencies concept. As soon as I was exposed to it, I extended it to all assets, including stocks. The Fed’s actions are “bullish” because as more “Bernankes”, known to you as Federal Reserve Notes float around, their value declines, raising stock prices expressed in Bernankes. In short, the Fed’s actions in reducing the dollar’s value, raise the dollar price of competing “currencies” like: Euros, Yen, Pounds and BGUs. BGUs? Yes, “Bill Gates Units”, which you call Microsoft. Bill Gates issues his own money too. Think about it. There has been a massive deflation since 1986 which prices are expressed in BGUs. There are thousands of competing currencies out there.

  11. groucho writes:

    Steve, what do you hear on currency intervention to support the dollar?

    ” The Gartman Letter referred to comments made by ECB executive board member Bini Smaghi in September, when he detailed how such an intervention could play out:

    * Step One: Monitoring and assessing exchange rate markets and developments, with a focus on underlying fundamentals.

    * Step Two: Discussing these developments with other major players to assess currency developments and policies.

    * Step Three: Making public statements on the situation.

    * Step Four: Intervening in the foreign exchange markets.

    Since verbal interventions have already begun, we are between steps three and four, with actual interventions due next, Mr. Gartman said. Mr. Smaghi has set the table for central banks and their governments around the world, he added.”

    In other words, the dollar bounced for the sole reason that the Fed and the rest of the world finally performed what is known as a currency intervention. The other central banks agreed to buy dollars. Nothing new, here.

    Everything Is Still the Same

    The end result of all of the above is that nothing has really changed – except for the thus-far undisclosed international dollar-support action. Other than that, everything is still the same.

    So, what was the real point of these actions? If the only change that has any kind of teeth was the coordinated dollar-support action, why did the world’s central banks not disclose that?

    Answer: Because everybody knows that such action would prop up the dollar and probably result in a correction in the commodities markets. Under those conditions, the battered US Fed would not be able to stand there and accept the adulation of the cheering masses as the “hero who saved the markets.”

  12. mp writes:

    I would hope that anyone using fundamental methods is also savvy enough to know that the current treasury rate is an anomaly.

  13. wimpie writes:

    Looks like the “global ppt” is now on duty:

    “The strength of the recent euro-dollar rally came as a surprise to many people, and such swift moves certainly raise the specter of coordinated central bank intervention,” said Hans-Guenter Redeker, global head of currency strategy in London at BNP Paribas SA, the most accurate forecaster in a 2007 Bloomberg survey. “As volatility rises, the likelihood of such an intervention increases.”

    `Disorderly Movements’

    After the Federal Reserve’s U.S. Trade Weighted Major Currency Dollar Index declined to 69.2631 on March 18, the lowest in 37 years, Redeker said he sees parallels between now and 1995. That was last time central banks stepped in to arrest a slide in the greenback by purchasing and selling currencies to influence exchange rates.

    The most obvious is implied volatility on options for the dollar, which rose to 14.5 percent last week, the same as in 1995 and up from the low this year of 9.62 percent on Feb. 26. Morgan Stanley is on “intervention watch,” Stephen Jen, the New York-based firm’s head of foreign exchange research, said March 14. ”

  14. Greg writes:

    My experience with DCFs has been to use a discount rate that matches time horizon with the model’s duration. Most DCFs model 10 years. I’ve often modeled further out – of course you can’t have much certainty what the world or company prospects will look like that far out, but that’s what discounting is for and you avoid the 80%-90% terminal value problem that way too.

    In any case, the so-called risk free rate (though definitely in no way free of risk as other posters have pointed out) should usually be the 10-year or 30-year which, while also down significantly, haven’t plummeted quite as far as the T-bill yields.

    And I would certainly add that equity premiums should rise at least as much as credit spreads have, since equity is further down the claim line, and therefore more risky than credit. Credit spreads have ballooned across the spectrum, equity spreads apparently haven’t. Regardless of changes to the risk free rate, there is absolutely a disconnect between the equity and credit markets.

  15. nick gogerty writes:

    here is a look at the equity premium. dow 8,800?

    dow too high?

    here is some data from US census in spreadsheet format on housing affordability.updated as of feb

    housing affordability