February 14, 2008

Credit vs. Equities

The two markets seem to behave in two different and diverging manner. Credit is almost non functional, while equities markets are posting strong rallies. Investors in one market seems to avoid risk and the other seems to welcome it.

The credit markets all but ceased to function, lets look at some recent events:
  1. Buyout debts are sitting on banks balance sheets with no takers to the tune of $200 billion, which means no lending to occur to businesses by these banks.
  2. The municipal bond auction market with no takers at 20% interest rate. The municipalities will have a tough time refinancing some of their obligations once they are due.
  3. Banks and investment dealers are not supporting the muni auction markets.
  4. The 30 year mortgage rates have not gone down with the 10 year treasury note yield, which should match the percentage decline more or less.
  5. The high yield and investment grade debt markets spread over treasuries have been rising steadily since late last year with no reprieve in sight. The spreads make for increase in financing costs if even available to some companies. The two graphs show the yield spread over treasuries for the high yield market and investment grade market.
One can argue that risk is being priced correctly as no high yield issue should only yield 200 basis points over the no risk treasuries.

So why is the equities market rallying? Well there is always the noise factor like retail sales are up, corporate profits in Q4 are up or talk about bailout this or bailout that...etc. All none meaningful events to the valuation of investment.

And given that financing costs are high valuation should go lower. High financing costs makes the cost of capital for some companies extremely high, which means valuation should be lower as you use a higher discount rate to value future cash flow streams, which makes them less in todays dollars.

Are these rallies sustainable? Who knows,
markets can stay irrational longer than we can stay liquid

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