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“Back that seems like almost we ve been doing it forever right. But this is is my sixth weekly update on the crisis. We ve been going through and it a little telling of the wallet during the previous weeks that last week seemed to be a quiet week. Because market news.
Only two or three percent a day huge by historical standards. But small relative to the weeks before and i m going to follow a familiar script as in the previous week. So when you list out what markets did last week. Look at the damage in equity markets around the world broken down by region broken down by sector broken down by industry and see where the damage is greatest.
But i m gonna spend some time in this update talking about what i talked become very for now. Which is the price of risk something have come back to over and over again because it centers might think so let s start by looking what last week delivered to referees across the world. It was for the most part of quietly if you define a quiet week as a week where markets normally two to three percent. The two exception for the nikkei which talked about eight percent in india was trucked about seven and a half percent but relative to prior weeks.
The week was acquired by that said the damage that was done over the previous month. Has been substantial in pretty much every market in fact. The only market. Which is single digit losses over the month is shanghai.
If you look at the treasury market again a quiet market rates crept up a little bit. But really not much relative to previous weeks. The treasury treasuries had a quiet way so equities had a relatively quiet week treasury said a quiet week. Did corporates reflected that default spreads edged up a little bit for the higher rating.
Classes and edged down a little bit for the lower rating classes. But overall not much was happening at the corporate bond market and finally we look at the commodity market. I focused on copper and oil as i have in previous weeks. And as with previous weeks.
Woodall did kind of broke with the norm. All had a very strong week especially toward the end of the rumors spread that saudi arabia and russia will come to an agreement kapur had a quietly and finally looking golden bitcoin as with every other market. It was a relatively quiet week. So in summary looking across all of the markets last week was a week.
What things seemed to settle down now before you heave a sigh of relief and say the crisis is over this could be the calm before another storm or it could be a break in the voluntary. Only the next few weeks would now looking at the equity debt of britain. Equities. By region you can look across reasons in every region again you see the reflection of what we saw in the indices.
The the markets all showed relatively small losses relative to previous weeks. And you can see that there was notes. There was no market with a double digit gain or loss. Which is unusual given what the previous weights look like but again.
If you look since february 14. The damage has been done the damage is substantial across all markets. China still remains the standard with the least damage. But not the story so that may be that the damage started before february 14.
But again not much change from the previous weeks looking across sectors again consumer staples and health care. It held up the sector. Though that did the best last week was a sector that beaten pretty but pretty badly punished in the previous weeks which dissented the rise in oil prices caused. The energy sector to do well and in fact its performance last week has removed it from the position of worst performing sector across the last six weeks and now in fact the worst performing sector is financials with a thirty two point three nine percent loss and you can see again the tilt towards more levered heavy infrastructure sectors.
Losing more katan market value then sectors that are less levered and infrastructure driven is pretty obvious looking at the most of the least damaged industries. The most damaged industries are familiar let s again infrastructure companies. Many of them with lots of debt and real estate is up there no but the best performing sectors last week. Many of the more energy sectors again the rise in oil prices product.
The price of energy stocks now again. I wouldn t he versailles relief. If you re an investment in energy company. Because who knows what this week will deliver for oil prices finally.
I looked at i broke down equities. But classism and now you re familiar i broke them down by p e ratio by momentum classes and by given in sin buybacks and i saw very little indication that the dam of systematic differences in damage across the classes. So the stories of high p e. Stocks at higher momentum stocks being punished.
There s no basis for that the only classification that seems to make a difference is net debt companies with a lot of net debt. I ll be absolutely punished more than companies with less debt and less than that so if there s any evidence out there that this is punishment that was long do for people who had written momentum or bought high crude stocks the evidence still is not there for that basis. I did add one more classification. I looked at companies that had borne rates and after tell you that this is a subset of my overall.
Sample overall. Said they re about 37000. Companies. All publicly traded companies.
The market cap greater than five million. But about two thousand two hundred these companies have bond ratings from s p. So i broke companies down the bond rating and here you see a very strong relationship between the bond rating. And the damage done the lower rate of the company is the greater the damage again this goes.
Along with the fact that debt has become the great differentiator in terms of damage in this particular get crisis. So now let s move on to the price of risk. I ve written and talked and worked on the price of risk for a long time in fact i have a paper on equity risk premium to do that i will put a link up to that you re welcome to read. But i have to warn you it s incredibly long boring.
And i fell asleep multiple times as i was writing the paper. But you might find it useful. But if that paper. I list out the determinants of the price risk you see what do you mean determinants.
The price of risk is set by the market in the bond market in the stock market in real estate. There is a price of risk. It s a demand and supply. But what drives a demand and supply.
The first is uncertainty about future economic growth. The more uncertain you feel about future economic growth. The higher your price for risk is going to be the second is if there s political stability. It s good for you.
But if it the greater the instability. The greater the price of rest the more worries you have about catastrophes and disasters. The greater the price of resting at that sound the hits are familiar. If that if that hits a chord for you right now.
I don t blame them you know the greater the risk aversion in the part of investors. The price of risky singing what drives risk aversion well. We know aged as older investors tend to be more risk averse. But also risk aversion that every bastard buries across time.
And let s face it we re all a little more risk averse. Now than we were eight weeks ago. And finally accessibility to information its reliability can drive the precipice the less reliable information. Is and the less accessible.
It is the higher the price risk the bottom line is if you look at those determinants. They re not fixed over time which means the price of risk should vary across time and i m going somewhere with this thought the way in which i will start to estimate the price of risk is to look backwards. It was a very static approach look at the historical premiums stocks have earned over t bo s dirty parts over the last 50 60 70 years that strikes me as a terrible way to think about the price risk because it keeps that number frozen. If i computed the number at startup on equity.
It s still there at that same number none doesn t make any sense. So let s talk about a market price risk starting with the easier market. The bond market in the bond market. When investors feel that there s a greater risk of default and they feel more risk.
Averse. You know what they do they not that the price of the bond. A push up the interest rate. The interest rate on a bond becomes a very simple proxy for the price of risk.
The higher the price of risk. The higher the spread you would demand on a bond relative to something risk rate. So you know what i ve done is to give it to give some historical perspectives. Have taken one bond ratings.
Class. B. Double. A which is equivalent of triple b and s p.
It s an investment grade bond and i ve looked at the default spread of this bond going back to 1960 for the most part it s pretty stable right except there are spots spikes when during recessions when you re worried about default and if you look at 2008. You get the biggest spike of all so during crises. The bond market price of risk does change. So i decide to take a look at the last crisis not this one.
But the previous one that two dozen many crises and what happened to bond market default spread. So here i ve broken down four different ratings classes. I m sorry in three different ratings classes across four different dates. The first is the start of 2008.
The second is september 12. 2008. Which to me was the official date of that crisis that friday before lehman. Collapse and then through the crisis.
And you can see that through the crisis. Default spreads widen. Not just a little but by a lot in fact in many of the ratings classes the default spreads. Almost double during the crisis to see what s happened here in this crisis.
Well. I m ready filled here. I have the default spreads on triple. A double a single a triple b bb.
Single b. And triplet c and below rated bonds. These are the spreads on merrill lynch. Maryland s drugs.
These indices based on these ratings. Classes across the days from february 14th through through today it through actually. April 3rd you can see that in the first couple of weeks of the crisis. The bond market seemed to be kind of taking it in stride.
Doing nothing and then it woke up the fact. Oh. My god there s a crisis. We could see a lot more defaults and you can see the price of risk rising.
Across the board default spreads. A prism and in fact they ve almost doubled over the last six weeks. Very similar to what happened in 2008. Reflecting worries what about the fourth and agreda worried about no greater risk aversion of the part of investors.
So. The bond market is reflecting them the crisis with a higher price versus. Now with the equity market. It s much more difficult to get a forward looking estimate at the present risk well they re a simple proxy that can be used is to take the inverse of the p e ratio.
It s called the earnings yield earnings surprise and some people argue that that number should get higher during the present. The only problem is to use trailing 12 month earnings in the earnings themselves are collapsing. It might not capture the crisis effect. There s another proxy that used which is the best.
Which is a very neat instrument. Which straits just and volatile so it s a it s a bet on molitor and if you trace the beggs from february 14. Through through april 3rd. You can see that the vix has been going a little crazy during this period.
That s of vixx s reached it reached a high of just above 80 on here you know april 19th. I m sorry march. 19th or 20th. So you can see the vix is being zigzagging and last week.
And a reflection of the of the lesser water in the vix came down to more manageable levels. But it stood far higher than historic not just to give you a sense of perspective. It was tucked around 15 forever and now it took off and it s now five times that number at the peak and still three times or four times that number even after it s headed up but i want a real measure of equity risk premiums and to those of you familiar what i ve been doing for a while both on my website and in this blog. I compute a forward looking risk premium for equity yes.
How i do it i start by looking at what. The index is so that s an observable number just like the border price. And it s a coupons on bonds. I look at expected cash flows on stocks now this is a little trickier because expected cash flows.
I have to forecast and there could be uncertain why because companies don t have to pay a fixed amount. There they might pay a dividend and they might buy back stock. But those numbers vary across time. So that s what i do i take a look you know my cash flows from last year projector in a normal period.
What those cash flows would look like in future years by tying it to the growth in earnings and then at the end of year five. I assume the cash flows would continue to grow at a rate that reflects the growth kennedy convenience. The risk free rate as a proxy and i solve for an internal rate of return that discount rate that makes the present value. If my cash flows equal to the level of the index think of this as an expected return on stocks i subtract out the risk free rate.
I get an implied equity risk premium. The nice thing about this number is its dynamic every time the index changes the number will change in fact. Let s take a very simple test. Let s say now nothing changes new cash flow.
The index drops by 10. What s gonna happen same cash flows lower price up front my internal rate of return is going to go up pyrus premium is going to call a market drop increases your risk cream. Actually the causality probably goes the other way people demand a higher if the market drops. If my cash flows drop.
And my price stays the same my internal rate of return decreases. My expected return decreases the tricky thing in a crisis is both the cash flows and the index level drop. But when i compute this on a day to day basis as i have during crisis you re going to see one of the prompts. I m going to run it but before i do that let me give you some historical perspective on that implied operator.
Screening this is the implied equity risk into the us going back to 1960 and you can see it s at zigzag periods 1970s it went out then it had a long bull market when the implied equity risk when dropped as low as 2 that s a dot com boom. Then you see the dot com bust and then you see the 2008 spike you know the lesson and learn under 2008. I used to compute these equity risk premium. So once you re at the start of the year and used them over the year then you got to 2008.
And i realized that this number was much more dynamic than i thought it was this is actually my computation of the implied equity risk premium during the 2008 crisis you can see if peaking on november 23rd. Or november 20th of 2008 and about close. To 8 at the end of the year was down. 264 but that was so substantially above the 42.
Percent. That you started the crisis at that was 2008. It could be the crisper the premium one of the problems. I ran in doing computing that premium during that period in a day to day basis.
I could update the index and the risk free rate every day that was fresh but the earnings and the cash flows. Don t get updated that frequently so i m probably overstating the jump in the risk premium. Because of keeping the cash flows. Relatively stale and updating the other numbers.
So i decided to do the same thing in this crisis. But i added on an additional implied accordance with what i allowed in the second approach to do is as i said look where the crisis. The earnings and the clothes might not have changed. Technically the annex might not tell me they ve changed.
But i know if they re going to drop because of this crisis. So what i did was that completely computed what i m going to call it cove it equity risk premium with the drop in earnings and a recovery later so i ve assumed that during this period. That started the period. I assumed about a 15 percent drop in s p 500 earnings by the time i got to the last two weeks that was that that was up to 30 percent.
You saying how could it change so much hey what the world changed around me. I got a lot more pessimistic about the effects on earnings. So you see the two numbers again you see the spike the unadjusted premium. Likened it as in 2008 peaked around march.
23rd at 775. The unadjusted premium also peaked that day. But at the lower number closer to. 7 and on april april 1st of.
2020 this premium was 60 1. Now again if you ve tracked my equity risk premiums like computers premiums by country i start with the implied premium for the us. And i do that but again. I do this only twice here.
What s the start and what s the middle of the earth. But this year is different the premiums are computed in january first 2020 are now no longer useful because so much has. Changed. So what s in an updated the premiums start over the 60.
1. Base. And then also adjusting my premiums for individual countries. In here.
The way they adjust the way i get my equity risk premium for individual countries. I started the default spread for the country based on the sovereign rating. Remember what happened the corporate spreads in those in these last six weeks they ve almost other the same things happened to sovereign spreads so my equity risk premiums for individual countries and now i are both because i have a higher base number and a higher added premium. So here s my april 1st 2020.
Update. And i want to put out the spreadsheet if you want to download it and look at it in detail. The green numbers are what the premiums look like on january 1st. The red numbers of my updated premiums look at how much they ve changed and here s the irony they ve changed more in emerging markets than in developed markets.
And that s in fact the nature of a crisis is the leap. The most emerging markets get hurt the most these higher risk premiums are what i plan to use going forward in evaluation. So in conclusion one of the biggest lessons. I learned from the 2008 crisis is don t trust static numbers risk premiums.
Our dynamics. Which means hurdle rate. Should be dynamic and have never understood companies that compute how to rates and stick with them for decades to me the expected return on stock should vary across time and the cost of capital should change over time. That s the endgame here is to come up with numbers that look like where we are not where we wish to be thank you very much for listening.
And i hope you found this ” ..
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