Tuesday, April 20, 2010

Risk Is Back

It is difficult to judge the market's appetite for risk simply on the basis of the equity markets' price levels, as determining what constitutes "too high" or "too low" a price is challenging. One can compare a market's price to its earnings or its book value, but earnings are a moving target and are subject to large non-recurring costs (even in the aggregate) while the efficiency with which assets and leverage are employed also changes.

Dividend yields are often used as an indicator of the market's appetite for risk, but increases/decreases in the utility of retained earnings (that is, do companies have opportunities to generate solid returns on earnings they do not pay out?) can render yield-comparison exercises ineffectual. Furthermore, the increasing and volatile use of stock buybacks as an alternative means of returning capital to shareholders adds uncertainty to such comparisons.

Nevertheless, there are means by which the market's general appetite for risk can be estimated. One such method uses the TED Spread, which measures the difference between inter-bank lending rates and US government debt, which is currently considered by many to be risk-free. A high spread (or large difference between bank rates and government rates) suggests investors are scared of lending, as perceived risk is high.

Consider the TED Spread over the last five years:

From the chart above, it is easy to see why economists were warning of a liquidity crisis in the fall of 2008, as spreads widened dramatically from their previous levels, and continued to rise until the end of the year. At such times, the cost of borrowing is exceedingly high as owners of cash were in no mood to provide capital.

But since May of 2009, spreads have declined dramatically. Not only have they recovered to their pre-crisis levels, they are below the spread levels seen in the last boom-cycle! Considering the economy is still in recovery mode, this eager willingness on the part of capital providers to take on risk is rather surprising. Lenders of capital to banks are currently asking just 15 basis points of return above what government debt returns, despite a rather fragile economy!

What does this mean for the stock market? Maybe nothing, maybe a lot! If investors are once again pricing assets such that they perceive little to no risk in them, prices could fall significantly the next time the market is spooked. The current level of the TED Spread suggests providers of capital are doing just that.

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