Sunday, July 4, 2010

Yields and Risk

Over the couple years I've blogged on the economy, I have been pretty bad at prediciting the behavior of the stock market. Despite this, I would like to share a couple of insights over this time.

I have blogged before on the inherent fluctuation of the market, as it swings back and forth around the trend line. Financial commentators will always have an explanation for why the DJIA went up or down 50 points today—they will always find some piece of economic news to link it to—but really, 50 points, and probably even 100, is well within the margin of error, so swings up and down of that degree are just artifactual noise and have no meaning. Admittedly, if you want to be invited back on CNBC as a financial commentator, you had better find a better answer than: "Today's 75 drop was probably mostly just random noise and bears no particular association with any financial event. It will probably reverse course tomorrow."

So today, I would like to discuss two other factors that play a role in stock valuations that buck the trend line and account for movement outside of the margin of error.

Yields are the bottom line of any investment. Unless an investment delivers a competitive yield, or return on your principle, it has no value as an investment. Now speculative run-ups can happen and have happened a lot lately where the prices of stocks or houses or whatever rise in a detached way from yields and people can make a lot of money from capital gains—but this is the definition of a bubble, and it is always time-limited and a risky game to play. In the heart of a bubble, investors will say things like "new paradigm" and believe that the principle is now detached from the yield, but sooner or later, things will return to earth. It is a speculative game and the last of the greater fools will eventually get burned.

While yields have generally been pretty low in the last rise of the DJIA, since its lows in the 6000s in March 2009, this last bull market may have actually been supported by fundamentals. The problem is, with the Federal Reserve lending out money at close to 0%, investments have not needed to perform very well to be marketable. If you are an investment bank that can borrow money from the Fed at, say, 1%, and then invest it in stocks with a meager 2 or 3% yield, that is still profitable. If interest rates are closer to their historical average at 5%, a 2 or 3% yield would be unprofitable, and the base price of stocks would have to fall before it would be sensible to buy them as an investment. The recent peak of the DJIA in the 11000s is understandable given the generally poor yields of all investment classes today.

A less tangible factor that affects stock valuations is risk. If one fears a business going bankrupt, even a 20% yield is uncompetitive if it causes you to lose your entire principle. If a business is extremely stable, its stock hardly needs to outperform treasury bonds to be a worthwhile investment. If the overall business environment is optimistic, yields can drop, raising the base price of the stock. Conversely in a worrisome climate, yields must rise for the stock to be competitive.

Since yields are fairly fixed and cannot go up or down on a whim, it is the principle, or base cost of the share, that must adjust to the desired yields. In a climate where low yields are tolerated then stocks prices have room to rise, or if higher yields are needed, then there is a downward pressure on share price.

So, random variations, yields, and risk are the current factors I have in my mind that account for shifts in the value of stock, or other investment classes. Random variations account for small changes of up to a few percentage points. Yields are straightforward and easy to measure, and if a stable corporation can outperform Treasury Bonds by a percentage point or two, its price is understandable and consistent with fundamentals.

Risk is the x-factor in all of this. It is hard for outsiders to gage what the inherent business outlook will be, and in addition, risk is mitigated by upcoming government bailouts which again is knowledge that will be privy only insiders.

The stock market has declined significantly lately. Though yields are poor they are in line with those of other investments. So, using this model, recent declines are accounted for by a general sense of risk in the system.

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