Broken Financials: Are Bank Stocks Going to Zero?
Posted Jan 22, 2009 03:39pm EST by Aaron Task in Investing, Banking, Housing
Related: XLF, BAC, JPM, FITB, NTRS, C, ^DJI
After hitting a 14-year low Tuesday, the financial sector enjoyed a reprieve Wednesday on news of some big purchases by insiders, namely JPMorgan CEO Jamie Dimon and Bank of America's Ken Lewis.
But the sector was back in the dregs Thursday on news of John Thain's ouster from Bank of America (and ridiculous spending spree), change at the very top of Citigroup and a big loss at Fifth Third Bancorp.
But with the financial sector now less than 10% of the S&P 500's market-cap (down from 22% at its peak) and so much bad news "priced in," there have to be bargains in the banks, right?
Wrong! says John Roque, technical analyst at Natixis Bleichroeder.
While he can find at least one bank stock worth investigating, Roque believes investors would be wise to avoid banks, homebuilders and other housing-related stocks for the foreseeable future.
"Those sectors have been broken and are not going to come back for a long time," he said, predicting it will be a very long time before these stocks return to their peaks, if ever.
Disclosure: Roque has no positions in any of the stocks mentioned in the accompanying video.
http://finance.yahoo.com/tech-ticker/article/162574/Broken-Financials-Are-Bank-Stocks-Going-to-Zero?tickers=XLF,BAC,JPM,FITB,NTRS,C,%5EDJI
Friday, 23 January 2009
Thursday, 22 January 2009
Social risk
Social risk
Social risk is difficult to quantify. It reflects the potentially adverse impact changing public attitudes can have on a firm’s ability to sell its product.
It is really a form of business risk that impacts a specific firm or industry.
· No one likes ugly smoke-stacks, for instance. Local opposition to apparent pollution might lead to a boycott of company products.
· Past examples of social risk issues include nuclear power, the spotted owl, furs, cigarette advertisements, concern with cholesterol, and the gasoline consumption of SUVs.
According to the Social Investment Forum, there is more than $2 trillion invested in socially screened portfolios in the United States. This is a 47% increase since 1999.
While there are various social screening criteria, avoiding tobacco investments is the most common.
Other criteria appearing in more than half of the institutional screens are related to
· the environment,
· human rights,
· employment/equality,
· gambling,
· alcohol, and
· weapons.
Less common criteria involve
· labour relations,
· animal testing/rights,
· community investing,
· community relations,
· executive compensation,
· abortion/birth control, and
· international labour standards.
Social investing does not necessarily avoid things; sometimes it seeks things out, and not always with good outcomes.
· In 1990 the state of Connecticut Employee Pension Plan, under political pressure, invested $25 million in the stock of Colt Firearms in order to keep 925 local jobs from being lost. Colt filed for bankruptcy 2 years later. This government attempt to help one group of citizens wound up hurting another, as the entire investment was lost.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Social risk is difficult to quantify. It reflects the potentially adverse impact changing public attitudes can have on a firm’s ability to sell its product.
It is really a form of business risk that impacts a specific firm or industry.
· No one likes ugly smoke-stacks, for instance. Local opposition to apparent pollution might lead to a boycott of company products.
· Past examples of social risk issues include nuclear power, the spotted owl, furs, cigarette advertisements, concern with cholesterol, and the gasoline consumption of SUVs.
According to the Social Investment Forum, there is more than $2 trillion invested in socially screened portfolios in the United States. This is a 47% increase since 1999.
While there are various social screening criteria, avoiding tobacco investments is the most common.
Other criteria appearing in more than half of the institutional screens are related to
· the environment,
· human rights,
· employment/equality,
· gambling,
· alcohol, and
· weapons.
Less common criteria involve
· labour relations,
· animal testing/rights,
· community investing,
· community relations,
· executive compensation,
· abortion/birth control, and
· international labour standards.
Social investing does not necessarily avoid things; sometimes it seeks things out, and not always with good outcomes.
· In 1990 the state of Connecticut Employee Pension Plan, under political pressure, invested $25 million in the stock of Colt Firearms in order to keep 925 local jobs from being lost. Colt filed for bankruptcy 2 years later. This government attempt to help one group of citizens wound up hurting another, as the entire investment was lost.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Political risk
Political risk
Political risk reflects the possibility that a foreign government will interfere with a firm’s preferred manner of conducting business.
The level of interference can be modest, such as requiring that a certain number of first-line supervisors be local nationals rather than “foreigners.”
More severe instances of political risk include:
· restrictions on the repatriation of dividends,
· mandatory local investments, or
· even the host-country government assuming control of the foreign firm through nationalization.
For multinational corporations, political risk is a fact of life. Firms learn to estimate the level of this risk in different parts of the world, as well as how to reduce its impact and to postpone or avoid its effects.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Political risk reflects the possibility that a foreign government will interfere with a firm’s preferred manner of conducting business.
The level of interference can be modest, such as requiring that a certain number of first-line supervisors be local nationals rather than “foreigners.”
More severe instances of political risk include:
· restrictions on the repatriation of dividends,
· mandatory local investments, or
· even the host-country government assuming control of the foreign firm through nationalization.
For multinational corporations, political risk is a fact of life. Firms learn to estimate the level of this risk in different parts of the world, as well as how to reduce its impact and to postpone or avoid its effects.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Foreign exchange risk
Foreign exchange risk
Foreign exchange risk reflects the possibility of loss due to adverse changes in the relative values of world currencies.
Suppose an investor buys securities in an Australian company for AUD25 at a time when the exchange rate is one Australian dollar per 75 cents U.S. One year later the share price is AUD30, and 70 cents will buy one Australian dollars.
· To an Australian, the shares appreciated by 20%, from AUD25 to AUD30.
· From the perspective of a U.S. investor, the adverse change in the exchange rate reduced the actual gain on the investment to 12%. The U.S. investor wants to begin and end with U.S. dollars.
· Foreign exchange risk reduced the true economic return from a U.S. investor’s perspective.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Foreign exchange risk reflects the possibility of loss due to adverse changes in the relative values of world currencies.
Suppose an investor buys securities in an Australian company for AUD25 at a time when the exchange rate is one Australian dollar per 75 cents U.S. One year later the share price is AUD30, and 70 cents will buy one Australian dollars.
· To an Australian, the shares appreciated by 20%, from AUD25 to AUD30.
· From the perspective of a U.S. investor, the adverse change in the exchange rate reduced the actual gain on the investment to 12%. The U.S. investor wants to begin and end with U.S. dollars.
· Foreign exchange risk reduced the true economic return from a U.S. investor’s perspective.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Interest rate risk
Interest rate risk
Interest rate risk is the chance of a loss in portfolio value due to an adverse change in interest rates.
When interest rates change, the value of a fixed income security also changes.
Rising interest rates depress bond prices, and vice versa.
Default risk: Default risk is the same as credit risk. It reflects the fact that a borrower might be unable or unwilling to honour the terms of an agreement to pay principal and interest on a loan.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Interest rate risk is the chance of a loss in portfolio value due to an adverse change in interest rates.
When interest rates change, the value of a fixed income security also changes.
Rising interest rates depress bond prices, and vice versa.
Default risk: Default risk is the same as credit risk. It reflects the fact that a borrower might be unable or unwilling to honour the terms of an agreement to pay principal and interest on a loan.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Purchasing power risk
Purchasing power risk
Purchasing power risk reflects the possibility that the rate of return on an investment will be insufficient to offset the rise in the cost of living.
During the early 1980s, the prime interest rate rose to 23% and inflation hit double-digit rates. At the same time, passbook savings accounts yielded about 5%. In retrospect, bank depositors would have been better advised to purchase canned goods and stack them in the basement. The interest earned from the savings account would have been insufficient to match the increase in the cost of food.
The stock market is generally considered to be a hedge against inflation. (Some analysts disagree with this generalization. Over long periods it is true; over shorter periods in history, it has not always been true.)
A well-diversified stock portfolio has little purchasing power risk, while an investment in fixed rate securities has plenty of it.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Purchasing power risk reflects the possibility that the rate of return on an investment will be insufficient to offset the rise in the cost of living.
During the early 1980s, the prime interest rate rose to 23% and inflation hit double-digit rates. At the same time, passbook savings accounts yielded about 5%. In retrospect, bank depositors would have been better advised to purchase canned goods and stack them in the basement. The interest earned from the savings account would have been insufficient to match the increase in the cost of food.
The stock market is generally considered to be a hedge against inflation. (Some analysts disagree with this generalization. Over long periods it is true; over shorter periods in history, it has not always been true.)
A well-diversified stock portfolio has little purchasing power risk, while an investment in fixed rate securities has plenty of it.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Financial risk
Financial risk
Financial risk is associated with the bottom of the income statement; it deals with earnings and how business risk and the financial structure of the firm impact them.
This type of risk is related to the firm’s use of financial leverage (debt).
Interest payments are fixed costs the firm must pay to stay out of bankruptcy, regardless of the firm’s profitability.
Some people, in fact, will say that a firm with no debt has no financial risk.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Financial risk is associated with the bottom of the income statement; it deals with earnings and how business risk and the financial structure of the firm impact them.
This type of risk is related to the firm’s use of financial leverage (debt).
Interest payments are fixed costs the firm must pay to stay out of bankruptcy, regardless of the firm’s profitability.
Some people, in fact, will say that a firm with no debt has no financial risk.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Business risk
Business risk
Business risk is the variability in a firm’s sales or in its ability to sell its product.
It is associated with the top of the income statement.
Business risk surfaces for a number of reasons.
Business risk is the variability in a firm’s sales or in its ability to sell its product.
It is associated with the top of the income statement.
Business risk surfaces for a number of reasons.
- For instance, consumer tastes may change.
- An automobile company might introduce a new compact car at a time when people are looking for larger luxury cars or minivans.
- A clothing manufacturer might be unable to react quickly to shifting fashion styles.
- Business risk also arises from macroeconomic changes, such as
- a recession leading to reduced consumer spending, or
- high interest rates making people reluctant to buy houses.
Also read: Understanding Risk
Partitioning Risk
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Partitioning Risk
Partitioning Risk
Risk has many subsets.
Total risk is all-inclusive and refers to the overall variability of the returns of a financial asset.
The two components of total risk are
· Un-diversifiable risk (also called systematic risk or market risk) and
· diversifiable risk (also called unsystematic risk).
Undiversifiable risk is that which must be borne by virtue of being in the market. This risk arises from systematic factors that affect all securities. We quantify systematic risk by beta.
Subsets of Risks:
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Risk and the Income Statement
Sales: Foreign exchange risk, Social risk, Business risk
Tax: Political risk
Dividends: Political risk
Contribution to Retained Earnings: Financial risk
Risk and the Balance Sheet
Total Assets
Financial assets: Interest rate risk, default risk, systematic and unsystematic risk, foreign exchange risk.
Real assets: Foreign exchange risk
Total Liabilities and Net Worth
Liabilities: Interest rate risk, foreign exchange risk
Net worth: Purchasing power risk
Risk has many subsets.
Total risk is all-inclusive and refers to the overall variability of the returns of a financial asset.
The two components of total risk are
· Un-diversifiable risk (also called systematic risk or market risk) and
· diversifiable risk (also called unsystematic risk).
Undiversifiable risk is that which must be borne by virtue of being in the market. This risk arises from systematic factors that affect all securities. We quantify systematic risk by beta.
Subsets of Risks:
Business risk
Financial risk
Purchasing power risk
Interest rate risk
Foreign exchange risk
Political risk
Social risk
Risk and the Income Statement
Sales: Foreign exchange risk, Social risk, Business risk
Tax: Political risk
Dividends: Political risk
Contribution to Retained Earnings: Financial risk
Risk and the Balance Sheet
Total Assets
Financial assets: Interest rate risk, default risk, systematic and unsystematic risk, foreign exchange risk.
Real assets: Foreign exchange risk
Total Liabilities and Net Worth
Liabilities: Interest rate risk, foreign exchange risk
Net worth: Purchasing power risk
Asian economic woe grows as China slows and Japanese exports plunge
Asian economic woe grows as China slows and Japanese exports plunge
China's economy may have ground to a halt entirely between the third and fourth quarters of last year and Japanese exports plunged 35pc in December, underlining the scale of the slowdown in Asia.
By Malcolm Moore in Shanghai
Last Updated: 7:39AM GMT 22 Jan 2009
China's national statistics bureau said gross domestic product had grown at an annual rate of 6.8pc in the fourth quarter of 2008, compared to a gain of 9pc in the previous three months.
The annual rate of growth for the world's third-largest economy was the lowest since the second quarter of 1998. "The international financial crisis is deepening and spreading with a continuing negative impact on the domestic economy," said Ma Jiantang, head of the statistics bureau.
Although the annual rate of growth was 6.8pc, economists speculated that the actual growth between September and December last year could have been zero, or even negative.
"My rough assumption is that it was basically zero," said Stephen Green, an economist at Standard Chartered bank in Shanghai. However, he added, recent revisions to Chinese GDP figures made an accurate calculation impossible. Mr Green also predicted that GDP may not grow in the first quarter of this year, compared to the last quarter.
Japanese exporters endured a torrid December as demand for a range of goods fell sharply. Exports to the US fell 26pc, those to Europe dropped 41.8pc and those to China were down 35pc.
In China, much of the slowdown has been blamed on a lack of demand from the rest of the world for Chinese-made goods. Wen Jiabao, the prime minister, said earlier this week that the outlook for Chinese employment is "very grim" as factories shut down and foreign companies rein in their spending.
Mr Wen will visit the UK next week, and Gordon Brown has already called upon him to make sure that China plays its part in stabilising the global economy. "We need China to play a full role, in partnership with us, if we are to restore confidence, growth and jobs," said Mr Brown.
China, however, has insisted that it must get its own house in order first, and there are indications that the government has already instructed banks to unleash credit into the market. The value of loans issued in November and December soared by nearly 19pc.
"It is hard to overestimate the potential importance of this," said Mr Green. "Mature economies' banking systems are currently flooded with liquidity that is not being lent out. China's interbank market is similarly flooded, but the difference is that the banks are lending."
The banks are likely to be ordered to finance a large chunk of the Pounds400 billion fiscal stimulus package that the Chinese government announced in November. There is a further Pounds2 trillion of spending demands from local governments across China that they may also be called upon to help with, irrespective of the possibility of bad loans.
Other bright spots included a slight rebound in industrial production growth to 5.7pc in December from 5.2pc in November, and a strong set of retail sales figures, where growth was 19pc.
Goldman Sachs, which issued one of the most bearish predictions for Chinese economic growth in 2009, at 6pc, admitted that there are "rising upside risks" that they may be incorrect, given the money flooding into the market.
"Our checks with commercial banks suggest the value of loans extended in January is likely to be even larger than the amount in December," said Yu Song, an economist at Goldman, adding that falling inflation also raised the possibility of further interest rate cuts.
However, Goldman said that China could be hit by even weaker export demand and maintained its prediction for now. "It is way too early to even claim the worst is over," said Mr Green. "Exports and domestic consumption, as well as profit growth, are now slowing and they will continue to grind lower over the year. Property still looks fragile, as does private investor sentiment. Even if we reach 8pc growth for this year, it will not feel like it," he added.
http://www.telegraph.co.uk/news/worldnews/asia/china/4312120/Asian-economic-woe-grows-as-China-slows-and-Japanese-exports-plunge.html
China's economy may have ground to a halt entirely between the third and fourth quarters of last year and Japanese exports plunged 35pc in December, underlining the scale of the slowdown in Asia.
By Malcolm Moore in Shanghai
Last Updated: 7:39AM GMT 22 Jan 2009
China's national statistics bureau said gross domestic product had grown at an annual rate of 6.8pc in the fourth quarter of 2008, compared to a gain of 9pc in the previous three months.
The annual rate of growth for the world's third-largest economy was the lowest since the second quarter of 1998. "The international financial crisis is deepening and spreading with a continuing negative impact on the domestic economy," said Ma Jiantang, head of the statistics bureau.
Although the annual rate of growth was 6.8pc, economists speculated that the actual growth between September and December last year could have been zero, or even negative.
"My rough assumption is that it was basically zero," said Stephen Green, an economist at Standard Chartered bank in Shanghai. However, he added, recent revisions to Chinese GDP figures made an accurate calculation impossible. Mr Green also predicted that GDP may not grow in the first quarter of this year, compared to the last quarter.
Japanese exporters endured a torrid December as demand for a range of goods fell sharply. Exports to the US fell 26pc, those to Europe dropped 41.8pc and those to China were down 35pc.
In China, much of the slowdown has been blamed on a lack of demand from the rest of the world for Chinese-made goods. Wen Jiabao, the prime minister, said earlier this week that the outlook for Chinese employment is "very grim" as factories shut down and foreign companies rein in their spending.
Mr Wen will visit the UK next week, and Gordon Brown has already called upon him to make sure that China plays its part in stabilising the global economy. "We need China to play a full role, in partnership with us, if we are to restore confidence, growth and jobs," said Mr Brown.
China, however, has insisted that it must get its own house in order first, and there are indications that the government has already instructed banks to unleash credit into the market. The value of loans issued in November and December soared by nearly 19pc.
"It is hard to overestimate the potential importance of this," said Mr Green. "Mature economies' banking systems are currently flooded with liquidity that is not being lent out. China's interbank market is similarly flooded, but the difference is that the banks are lending."
The banks are likely to be ordered to finance a large chunk of the Pounds400 billion fiscal stimulus package that the Chinese government announced in November. There is a further Pounds2 trillion of spending demands from local governments across China that they may also be called upon to help with, irrespective of the possibility of bad loans.
Other bright spots included a slight rebound in industrial production growth to 5.7pc in December from 5.2pc in November, and a strong set of retail sales figures, where growth was 19pc.
Goldman Sachs, which issued one of the most bearish predictions for Chinese economic growth in 2009, at 6pc, admitted that there are "rising upside risks" that they may be incorrect, given the money flooding into the market.
"Our checks with commercial banks suggest the value of loans extended in January is likely to be even larger than the amount in December," said Yu Song, an economist at Goldman, adding that falling inflation also raised the possibility of further interest rate cuts.
However, Goldman said that China could be hit by even weaker export demand and maintained its prediction for now. "It is way too early to even claim the worst is over," said Mr Green. "Exports and domestic consumption, as well as profit growth, are now slowing and they will continue to grind lower over the year. Property still looks fragile, as does private investor sentiment. Even if we reach 8pc growth for this year, it will not feel like it," he added.
http://www.telegraph.co.uk/news/worldnews/asia/china/4312120/Asian-economic-woe-grows-as-China-slows-and-Japanese-exports-plunge.html
Wednesday, 21 January 2009
Risk Aversion
Risk Aversion
One of the key concepts in finance is the fact that a safe dollar is worth more than a risky dollar.
This important principle compares one safe dollar with one risk dollar. Any one who invests in the stock market is exchanging bird –in-the-hand safe dollars for a chance at a greater number of future dollars.
It is wrong to say that a risk-averse person will not take a risk. We are all risk averse, yet we take risks all the time.
----
Risk Aversion and Rational People
Suppose a person is given a choice between the following two alternatives:
Alternative A $100 for certain
Alternative B 50% chance of $100, 50% chance of $0
No rational person would select B. Its average payoff is $50, only half what A offers with certainty.
Now consider another set of choices:
Alternative C $100 for certain
Alternative D 50% chance of $0, 50% chance of $200
D has an average payoff of $100, the same as C.
C, however, is safer than D.
People do not like a risk, and a rational person will choose the certain $100 over the risky $100.
Let’s now consider a more complicated example.
On a television game show, a contestant wins the right to spin a lottery wheel once. The wheel shows numbers 1 through 100, and a pinter selcts one number when the wheel stops. Which payoff schedule should the contestant choose from the four choices listed below.
Choice 1
Resulting Number….Payoff
1-50….$110
51-100….$90
Avg….$100
Choice 2
Resulting Number….Payoff
1-50….$200
51-100….$0
Avg….$100
Choice 3
Resulting Number….Payoff
1-90….$50
91-100….$550
Avg….$100
Choice 4
Resulting Number….Payoff
1-99….$1000
100….-$89,000
Avg….$100
Each of the choices has the same average payoff, but the consequences of the two possible outcomes with each choice vary widely.
Choice 1 is the safest alternative in the minds of many people.
Choice 2 offers a reasonable shot at $200. People who select this option reasons, “If my number doesn’t come up, at least I haven’t lost anything.” From an economic point of view, this logic is faulty. The person did lose something: the certain minimum payoff of $90 associated with Choice 1; this loss is an opportunity cost.
In other words, by choosing 1, a contestant will get at least $90. But the contestant gives up at least $90 in exchange for a try at a bigger return with the other choices.
Choice 3 offers a much higher possible return than 2 but ensures a payoff of at least $50. Some people select this option partly because of the entertainment value of the game.
What about Choice 4, with its high likelihood of a $1,000 payout? If the lottery wheel stops on the number 100, however, the contestant suffers a huge loss. Some people (and some investment portfolios) cannot tolerate any chance of such a loss and consequently could not seriously consider an option such as Choice 4.
Each of these alternatives has analogies in the investment world.
Choice 1 is much like buying shares of a conservative electric utility stock.
Choice 2 is akin to purchasing a stock option.
Choice 3 might be a convertible bond, with its assurance of steady interest income, and a chance for large gains if the underlying stock rises sharply.
Choice 4 is similar to a program of writing naked, out-of-the-money call options. With such a program the likelihood is high that the options will expire worthless (to the call writer’s benefit), but there is also a small chance that the options will become extremely valuable, in which case the call writer is in deep trouble.
----
Risk and Time
Peter L. Bernstein, founder of the Journal of Portfolio Management and well respected on Wall Street, said, “Risk and time are dancing partners in an eternal dance.” It is easy to overlook this important point. Probability theory deals with HOW MUCH and HOW LIKELY but says nothing about WHEN. The market crashed in 1929 and in 1987. It is likely to do so again.
Bernstein also said, “Risk and time are opposite sides of the same coin.” How likely is the market to crash tomorrow? A betting person (which investment analysts and advisors typically will not admit to being) is more likely to put money on NO CRASH tomorrow.
On the other hand, how likely is a market crash sometime in the next 50 years? This time frame puts a different light on the situation; most people certainly would agree that the probability of a crash anytime in the next 50 years is greater than the probability of a crash tomorrow.
In finance, we typically measure risk by the variance or standard deviation of returns. Daily returns are different from weekly, monthly, or annual returns. For returns to be comparable, we must measure them over consistent time intervals. The dispersion of a forecast (such as a future stock price) increases indefinitely as the length of the forecast (or holding period) approaches infinity. Logically speaking, the standard deviation of daily stock returns is smaller than the standard deviation of annual returns.
It is important to note that while the returns over a long horizon may be more uncertain, history suggests that over long periods of time there is also less likelihood that the investment will lose money.
Consider the information in Table below:
http://spreadsheets.google.com/ccc?key=pJV5vBExPQ_AehxWIo5vCRA&hl=en
These figures are the result of a 2,500 trial simulation of a $1,000 stock investment assuming an average annual return of 12%, but with a 20% annual standard deviation.
The longer the term of the investment, the greater is the mean return - but the greater the range between the minimum and maximum values.
Note also the longer the term of the investment, the less the likelihood of losing money and the greater the likelihood that the investment will at least keep up with an assumed average inflation rate of 3%.
----
Summary:
It is wrong to say that a risk averse person will not take a risk.
People have different degrees of risk aversion; some people are more willing to take a chance than are others.
An opportunity cost is what is given up in exchange for a chance at something better.
"Risk and time are dancing partners in an eternal dance." - Peter Bernstein
Forecast variance increases indefinitely as the length of the forecast period approaches infinity.
One of the key concepts in finance is the fact that a safe dollar is worth more than a risky dollar.
This important principle compares one safe dollar with one risk dollar. Any one who invests in the stock market is exchanging bird –in-the-hand safe dollars for a chance at a greater number of future dollars.
It is wrong to say that a risk-averse person will not take a risk. We are all risk averse, yet we take risks all the time.
----
Risk Aversion and Rational People
Suppose a person is given a choice between the following two alternatives:
Alternative A $100 for certain
Alternative B 50% chance of $100, 50% chance of $0
No rational person would select B. Its average payoff is $50, only half what A offers with certainty.
Now consider another set of choices:
Alternative C $100 for certain
Alternative D 50% chance of $0, 50% chance of $200
D has an average payoff of $100, the same as C.
C, however, is safer than D.
People do not like a risk, and a rational person will choose the certain $100 over the risky $100.
Let’s now consider a more complicated example.
On a television game show, a contestant wins the right to spin a lottery wheel once. The wheel shows numbers 1 through 100, and a pinter selcts one number when the wheel stops. Which payoff schedule should the contestant choose from the four choices listed below.
Choice 1
Resulting Number….Payoff
1-50….$110
51-100….$90
Avg….$100
Choice 2
Resulting Number….Payoff
1-50….$200
51-100….$0
Avg….$100
Choice 3
Resulting Number….Payoff
1-90….$50
91-100….$550
Avg….$100
Choice 4
Resulting Number….Payoff
1-99….$1000
100….-$89,000
Avg….$100
Each of the choices has the same average payoff, but the consequences of the two possible outcomes with each choice vary widely.
Choice 1 is the safest alternative in the minds of many people.
Choice 2 offers a reasonable shot at $200. People who select this option reasons, “If my number doesn’t come up, at least I haven’t lost anything.” From an economic point of view, this logic is faulty. The person did lose something: the certain minimum payoff of $90 associated with Choice 1; this loss is an opportunity cost.
In other words, by choosing 1, a contestant will get at least $90. But the contestant gives up at least $90 in exchange for a try at a bigger return with the other choices.
Choice 3 offers a much higher possible return than 2 but ensures a payoff of at least $50. Some people select this option partly because of the entertainment value of the game.
What about Choice 4, with its high likelihood of a $1,000 payout? If the lottery wheel stops on the number 100, however, the contestant suffers a huge loss. Some people (and some investment portfolios) cannot tolerate any chance of such a loss and consequently could not seriously consider an option such as Choice 4.
Each of these alternatives has analogies in the investment world.
Choice 1 is much like buying shares of a conservative electric utility stock.
Choice 2 is akin to purchasing a stock option.
Choice 3 might be a convertible bond, with its assurance of steady interest income, and a chance for large gains if the underlying stock rises sharply.
Choice 4 is similar to a program of writing naked, out-of-the-money call options. With such a program the likelihood is high that the options will expire worthless (to the call writer’s benefit), but there is also a small chance that the options will become extremely valuable, in which case the call writer is in deep trouble.
----
Risk and Time
Peter L. Bernstein, founder of the Journal of Portfolio Management and well respected on Wall Street, said, “Risk and time are dancing partners in an eternal dance.” It is easy to overlook this important point. Probability theory deals with HOW MUCH and HOW LIKELY but says nothing about WHEN. The market crashed in 1929 and in 1987. It is likely to do so again.
Bernstein also said, “Risk and time are opposite sides of the same coin.” How likely is the market to crash tomorrow? A betting person (which investment analysts and advisors typically will not admit to being) is more likely to put money on NO CRASH tomorrow.
On the other hand, how likely is a market crash sometime in the next 50 years? This time frame puts a different light on the situation; most people certainly would agree that the probability of a crash anytime in the next 50 years is greater than the probability of a crash tomorrow.
In finance, we typically measure risk by the variance or standard deviation of returns. Daily returns are different from weekly, monthly, or annual returns. For returns to be comparable, we must measure them over consistent time intervals. The dispersion of a forecast (such as a future stock price) increases indefinitely as the length of the forecast (or holding period) approaches infinity. Logically speaking, the standard deviation of daily stock returns is smaller than the standard deviation of annual returns.
It is important to note that while the returns over a long horizon may be more uncertain, history suggests that over long periods of time there is also less likelihood that the investment will lose money.
Consider the information in Table below:
http://spreadsheets.google.com/ccc?key=pJV5vBExPQ_AehxWIo5vCRA&hl=en
These figures are the result of a 2,500 trial simulation of a $1,000 stock investment assuming an average annual return of 12%, but with a 20% annual standard deviation.
The longer the term of the investment, the greater is the mean return - but the greater the range between the minimum and maximum values.
Note also the longer the term of the investment, the less the likelihood of losing money and the greater the likelihood that the investment will at least keep up with an assumed average inflation rate of 3%.
----
Summary:
It is wrong to say that a risk averse person will not take a risk.
People have different degrees of risk aversion; some people are more willing to take a chance than are others.
An opportunity cost is what is given up in exchange for a chance at something better.
"Risk and time are dancing partners in an eternal dance." - Peter Bernstein
Forecast variance increases indefinitely as the length of the forecast period approaches infinity.
Safe and Risky Investments
Safe and Risky Investments
Joe Conservative hates risk and is terrified of the prospects of losing money. He is strictly a bank CD man, being highly suspicious of the stock market. His girlfriend, Rita Riskaverse, doesn’t like risk either, but she studied investments in college and knows something about the relationship between risk and return.
Joe and Rita eventually get married but decide it makes sense for them to handle their investments individually. Joe puts $100,000 in a bank certificate of deposit earning 6% annually, while Rita spreads her $100,000 equally across five stocks, putting $20,000 in each one.
Twenty years later the two lovebirds decide to do some joint financial planning, which requires them to disclose the performance of their personal investment accounts.
Rita does some calculations on the performance of her five stocks. She tells Joe “I had one stock go bankrupt, two that earned less than your 6% from the bank, one that earned 8%, and one that earned 12%.”
Joe responds, “I told you the stock market was too risky. You should have listened to me.”
Suppressing a smirk, Rita shows Joe the data below.
----
Joes’s Bank CD:
$100,000 x (1.06)^20 = $320,714
Rita’s Stocks:
Stock A: worthless $0
Stock B: $20,000 x (1.03)^20 = $36,122
Stock C: $20,000 x (1.05)^20 = $53,066
Stock D: $20,000 x (1.08)^20 = $93,219
Stock E: $20,000 x (1.12)^20 = $192,926
Total = $375,373
----
Joe can’t believe it. Rita had one stock go under, two that were below-average performers, and two that did okay but certainly didn’t set the world on fire. It seems like luck to him that her portfolio is worth more than his – although he can’t put his finger on what was lucky. It just doesn’t seem fair.
Joe Conservative hates risk and is terrified of the prospects of losing money. He is strictly a bank CD man, being highly suspicious of the stock market. His girlfriend, Rita Riskaverse, doesn’t like risk either, but she studied investments in college and knows something about the relationship between risk and return.
Joe and Rita eventually get married but decide it makes sense for them to handle their investments individually. Joe puts $100,000 in a bank certificate of deposit earning 6% annually, while Rita spreads her $100,000 equally across five stocks, putting $20,000 in each one.
Twenty years later the two lovebirds decide to do some joint financial planning, which requires them to disclose the performance of their personal investment accounts.
Rita does some calculations on the performance of her five stocks. She tells Joe “I had one stock go bankrupt, two that earned less than your 6% from the bank, one that earned 8%, and one that earned 12%.”
Joe responds, “I told you the stock market was too risky. You should have listened to me.”
Suppressing a smirk, Rita shows Joe the data below.
----
Joes’s Bank CD:
$100,000 x (1.06)^20 = $320,714
Rita’s Stocks:
Stock A: worthless $0
Stock B: $20,000 x (1.03)^20 = $36,122
Stock C: $20,000 x (1.05)^20 = $53,066
Stock D: $20,000 x (1.08)^20 = $93,219
Stock E: $20,000 x (1.12)^20 = $192,926
Total = $375,373
----
Joe can’t believe it. Rita had one stock go under, two that were below-average performers, and two that did okay but certainly didn’t set the world on fire. It seems like luck to him that her portfolio is worth more than his – although he can’t put his finger on what was lucky. It just doesn’t seem fair.
The Problem with Losses
The Problem with Losses
Big Losses
This investment has an expected return of 9.50%. Standard statistical thinking tells us if we invest in this stock and hold it, some years we will have high returns and some years low returns, but that, on average, the return will be 9.50%. This assumption is true, but it is also a potentially misleading result.
Suppose an investor buys this stock and holds it 10 years. In each of 9 of these years, the stock advances 20%; in the other year it falls 90%. The 10 year arithmetic average return is 9%
{=(9x20% - 90%)/10}, slightly below the return predicted by the distribution.
In reality, a $1000 investment, however, would be worth only $1,000(1.20^9)(0.10) = $516, less than the starting value! The compound annual rate of return is a negative 6.40%.
Learning points:
An example will show why. Suppose the proverbial statistical marble jar contains two colors of marbles: red and green. The red marbles symbolize a 10% gain in the stock market, while the green marbles symbolize a 10% loss. If, in simulating an investment and taking a number of marbles from the jar, we draw exactly the same number of red and green marbles, how did the investment fare?
The return is negative, but there is no way to tell how badly things turned out, because what matters is not the proportion of winners to losers, but the number of losers.
Learnng point:
Over time, even small losses can be a problem if too many of them occur.
The maximum loss, however, increases with each succeeding toss of the coin. The maximum loss after one flip is $0.50, after two flips is $1.00 and after three is $1.50.
If you define risk as the probability of losing money, then risk decreases as the time horizon increases.
However, if you define risk as the amount of money you might lose, it increases as the time horizon lengthens.
Learning points:
Big Losses
This investment has an expected return of 9.50%. Standard statistical thinking tells us if we invest in this stock and hold it, some years we will have high returns and some years low returns, but that, on average, the return will be 9.50%. This assumption is true, but it is also a potentially misleading result.
Suppose an investor buys this stock and holds it 10 years. In each of 9 of these years, the stock advances 20%; in the other year it falls 90%. The 10 year arithmetic average return is 9%
{=(9x20% - 90%)/10}, slightly below the return predicted by the distribution.
In reality, a $1000 investment, however, would be worth only $1,000(1.20^9)(0.10) = $516, less than the starting value! The compound annual rate of return is a negative 6.40%.
Learning points:
- A large one-period loss can overwhelm a series of gains.
- If an initial investment falls by 50%, for instance, it must gain 100% to return to its original value.
- Big losses complicate actual returns, and investors learn to avoid situations where they may lurk.
Small Losses
Over time, even small losses can be a problem if too many of them occur.An example will show why. Suppose the proverbial statistical marble jar contains two colors of marbles: red and green. The red marbles symbolize a 10% gain in the stock market, while the green marbles symbolize a 10% loss. If, in simulating an investment and taking a number of marbles from the jar, we draw exactly the same number of red and green marbles, how did the investment fare?
The return is negative, but there is no way to tell how badly things turned out, because what matters is not the proportion of winners to losers, but the number of losers.
As the number of draw increases, the terminal value of the investment declines.
After about 1,000 draws from the jar, the investment is nearly worthless. #
# In the stock market, such an investment could not survive. No security should have an expected return of zero. No one would buy it. Consequently, its price would fall until it offered a return consistent with its risk.Learnng point:
Over time, even small losses can be a problem if too many of them occur.
Risk and the Time Horizon
- the probability of losing money and
- the amount of money that you might lose.
The maximum loss, however, increases with each succeeding toss of the coin. The maximum loss after one flip is $0.50, after two flips is $1.00 and after three is $1.50.
If you define risk as the probability of losing money, then risk decreases as the time horizon increases.
However, if you define risk as the amount of money you might lose, it increases as the time horizon lengthens.
Learning points:
- In general, the longer you hold a common stock investment, the lower the likelihood that you will lose money.
- On the other hand, the longer you hold the investment, the greater the amount you might lose.
- The extent of the risk depends on how you define it.
Advice for Uncertain Times
Ben Stein How Not to Ruin Your Life
Advice for Uncertain Times
by Ben Stein
Posted on Tuesday, January 20, 2009, 12:00AM
The night before Dr. Martin Luther King, Jr., was assassinated in Memphis, he gave a memorable, inspiring speech. At its end, he said, "I don't know what's going to happen with me now. We've got some difficult days ahead...."
Unfortunately, this is true now about the American (and global) economy. I wish I could say I knew what was going to happen in the future. I have learned that I do not. I was not given the gift or the burden of foresight. I thought that our government would not let the bottom fall out. I was wrong. I am sorry.
So given that I do not know the future, what can I tell you that will be useful? Actually, quite a bit.
Cash Really Is King
First, taking the advice of my dear pal Ray Lucia, rock and roll star and investment guru, I can tell you that, no matter what happens, it will be good to have a nice chunk of money in cash or near cash. Yes, I know we may soon have inflation. But if we do, the rates on money market funds will rise. Cash is just a lovely thing to have in almost situation. Cash or near cash offers a level of comfort that even a large portfolio of stocks does not offer.
Taking a cue from my dear pal Phil DeMuth of Conservative Wealth Management, I can tell you that, if you think we are definitely at a bottom, you might be fooled. While Phil's research tells us that we may be near a bottom by postwar metrics of price, price to earnings, and price to dividends, we may have ( as Phil puts it ) "jumped the tracks of history."
My own view is that we have been fooled so much in the past 15 months about what real earnings are, what real book value is, that we cannot trust the data given to us. Yes, by current price-earnings measures, stocks look fairly reasonable. But we don't really know what true earnings are. That is the vicious truth. So if we are in the quicksand of not being able to rely on the data our companies give out, then anything can happen. Yes, we may be at a bottom or near it. Or we may not be anywhere near a bottom.
Anything Can Happen
Just to illustrate, who would have dreamed a few weeks ago that Citi would be in the kind of trouble it is in, even after a $45 BILLION infusion from the federal government? Anything can happen in the treacherous world in which we find ourselves.
Third, taking counsel from my pal Barron Thomas, very possibly the best salesman on the planet, I will tell you a rule of indisputable value in this or any economic situation: WORK.
Barron is in the real estate and private plane businesses. These are both highly impacted by the economic slowdown. How does Barron deal with it? He gets up at 5 a.m. every day and works the phones from 7 a.m. to 7 p.m., goes home, makes notes, and then sleeps well until he starts all over again. And he closes the deals. There are still plenty of people who will make the deal at the right price.
Keep on Working
Next, from yours truly: Work is deeply therapeutic. It makes us feel better. It gives us a much better attitude about ourselves. It makes us feel as if we are worth something. A middle class person who works has a far better self image than a rich person who does not work. Work is a gift, a sacrament, a true blessing. Plus, people who work are generally going to have higher incomes and higher standards of life than people who do not work.
If times are tough, work harder than ever. You will get through the rough patches and learn how strong you really are. Do not seek to avoid work -- embrace it.
Then, finally, I will tell you something I do when I feel buffeted by the markets. I dig into the 12-step program that has saved my life for the past 20 years. Using its precepts, I say to myself, "I am powerless over the stock market. It is all up to God. I do the very best I can, and after that, it's up to God."
Know What's Important
If you don't believe in God, then you can substitute "fate." Powerlessness is a huge source of power. Try it. You will like it.
"We shall overcome," we used to sing at civil rights demonstrations when we were getting tear gassed. "We are not afraid." Now I lie in bed at night and say to myself that if the men and women at military hospitals in this country and abroad can get through what they do, if their families can go through what they go through, then I can deal with market volatility -- trivial by comparison.
And so -- here it is. I do not know how it -- the stock market and economic turmoil -- will end, but to paraphrase The Bard, it will end, and that suffices.
http://finance.yahoo.com/expert/article/yourlife/135453
Advice for Uncertain Times
by Ben Stein
Posted on Tuesday, January 20, 2009, 12:00AM
The night before Dr. Martin Luther King, Jr., was assassinated in Memphis, he gave a memorable, inspiring speech. At its end, he said, "I don't know what's going to happen with me now. We've got some difficult days ahead...."
Unfortunately, this is true now about the American (and global) economy. I wish I could say I knew what was going to happen in the future. I have learned that I do not. I was not given the gift or the burden of foresight. I thought that our government would not let the bottom fall out. I was wrong. I am sorry.
So given that I do not know the future, what can I tell you that will be useful? Actually, quite a bit.
Cash Really Is King
First, taking the advice of my dear pal Ray Lucia, rock and roll star and investment guru, I can tell you that, no matter what happens, it will be good to have a nice chunk of money in cash or near cash. Yes, I know we may soon have inflation. But if we do, the rates on money market funds will rise. Cash is just a lovely thing to have in almost situation. Cash or near cash offers a level of comfort that even a large portfolio of stocks does not offer.
Taking a cue from my dear pal Phil DeMuth of Conservative Wealth Management, I can tell you that, if you think we are definitely at a bottom, you might be fooled. While Phil's research tells us that we may be near a bottom by postwar metrics of price, price to earnings, and price to dividends, we may have ( as Phil puts it ) "jumped the tracks of history."
My own view is that we have been fooled so much in the past 15 months about what real earnings are, what real book value is, that we cannot trust the data given to us. Yes, by current price-earnings measures, stocks look fairly reasonable. But we don't really know what true earnings are. That is the vicious truth. So if we are in the quicksand of not being able to rely on the data our companies give out, then anything can happen. Yes, we may be at a bottom or near it. Or we may not be anywhere near a bottom.
Anything Can Happen
Just to illustrate, who would have dreamed a few weeks ago that Citi would be in the kind of trouble it is in, even after a $45 BILLION infusion from the federal government? Anything can happen in the treacherous world in which we find ourselves.
Third, taking counsel from my pal Barron Thomas, very possibly the best salesman on the planet, I will tell you a rule of indisputable value in this or any economic situation: WORK.
Barron is in the real estate and private plane businesses. These are both highly impacted by the economic slowdown. How does Barron deal with it? He gets up at 5 a.m. every day and works the phones from 7 a.m. to 7 p.m., goes home, makes notes, and then sleeps well until he starts all over again. And he closes the deals. There are still plenty of people who will make the deal at the right price.
Keep on Working
Next, from yours truly: Work is deeply therapeutic. It makes us feel better. It gives us a much better attitude about ourselves. It makes us feel as if we are worth something. A middle class person who works has a far better self image than a rich person who does not work. Work is a gift, a sacrament, a true blessing. Plus, people who work are generally going to have higher incomes and higher standards of life than people who do not work.
If times are tough, work harder than ever. You will get through the rough patches and learn how strong you really are. Do not seek to avoid work -- embrace it.
Then, finally, I will tell you something I do when I feel buffeted by the markets. I dig into the 12-step program that has saved my life for the past 20 years. Using its precepts, I say to myself, "I am powerless over the stock market. It is all up to God. I do the very best I can, and after that, it's up to God."
Know What's Important
If you don't believe in God, then you can substitute "fate." Powerlessness is a huge source of power. Try it. You will like it.
"We shall overcome," we used to sing at civil rights demonstrations when we were getting tear gassed. "We are not afraid." Now I lie in bed at night and say to myself that if the men and women at military hospitals in this country and abroad can get through what they do, if their families can go through what they go through, then I can deal with market volatility -- trivial by comparison.
And so -- here it is. I do not know how it -- the stock market and economic turmoil -- will end, but to paraphrase The Bard, it will end, and that suffices.
http://finance.yahoo.com/expert/article/yourlife/135453
UK cannot take Iceland's soft option
UK cannot take Iceland's soft option
The British government faces an excruciating choice. It cannot let Royal Bank of Scotland and its fellow mega-banks go to the wall. Yet it risks being swamped by the massive foreign debts of these lenders if it takes on their dollar, euro and yen exposure by opting for full nationalisation.
By Ambrose Evans-PritchardLast Updated: 7:00PM GMT 20 Jan 2009
Comments 0 Comment on this article
Britain has foreign reserves of under $61bn dollars (£43.7bn), less than Malaysia or Thailand. The foreign liabilities of the UK banks are $4.4 trillion – or twice annual GDP – according to the Bank of England. The mismatch is perilous.
It is why sterling has crashed 10 cents from $1.49 to $1.39 against the dollar in two days. The markets have given their verdict on Gordon Brown's latest effort to "save the world".
Credit default swaps (CDS) measuring risk on British debt have reached an all-time high of 125, just below Portugal. The yield spread on 10-year Gilts over German Bunds has doubled to 53 since last week.
Standard & Poor's has quashed rumours that it will soon strip Britain of its AAA credit rating – an indignity averted even after the International Monetary Fund bail-out in 1976. But there was a sting yesterday as it responded to the Treasury plan for the banks. "Market confidence in the sector has eroded to such a degree that it is not clear whether these measures by themselves will bring about a material improvement," the IMF said. "As a result, full nationalisation of some banks remains a possibility in our view."
Spain was relegated from AAA to AA+ on Monday, and Spain's public debt is a much lower share of GDP.
"If Spain can get downgraded, then the risks for the UK are self-evident," said Graham Turner, of GFC Economics. "The increase in the UK gross public debt burden – 11.8 percentage points in just one year – is troubling. The market rightly fears the long-term fiscal costs of a collapsing banking system. Rising Gilt yields are the main impact of the botched move from the UK Treasury."
Mr Turner said the British Government had taken far too long to resort to quantitative easing – printing money – and had wasted months with fiscal frippery as debt deflation throttled the banks.
The parallels with Iceland are disturbing. The country was ruined by the antics of its three big banks. They built up foreign liabilities equal to 900pc of GDP. Operating as hedge funds, they borrowed in dollars, euros and pounds to speculate. However, the state lacked the foreign reserves to match this leverage.
But Iceland at least had the luxury of letting banks default – shifting losses on to the rest of the world. It refused to honour foreign debts.
"They drew a line," said Jerry Rawclifffe, who tracks Iceland for Fitch Ratings. "They created new banks, parking the old losses in resolution committees. It is not easy for other governments to walk away. They have a duty of care."
Indeed, if Britain walked away from UK banks' $4.4 trillion of foreign liabilities – worth eight times Lehman Brothers – it would destroy the credibility of the City and take the whole world into deeper depression.
"The UK cannot go down that route because it would set off an asset price death spiral," said Marc Ostwald, a bond expert at Monument Securities. "The Western banking system is already on life support. That would turn it off altogether."
So whatever the temptations, and whatever the feelings of righteousness over the follies of the RBS leadership in its debt-driven campaign of Napoleonic expansion, the Treasury is wedded to the banks and all their sins. Chancellor Alistair Darling cannot copy Iceland.
S&P's lead UK analyst, Trevor Cullinan, said the Government faces a "severe test" and will be judged by its actions, but he doubts whether matters will reach such a dangerous pass.
"The challenges to UK banks are significant amid a correction in property prices and a contraction of GDP. Nevertheless, the situation is very different from Iceland. The UK benefits from sterling, which is a major global funding currency. UK access to external funding is far more secure. In a worst-case scenario we estimate the cost of recapitalising the UK banking system to be in the region of £83bn (5.7pc of GDP)," he said.
The Government can take out derivatives contracts on currency markets to hedge the foreign debt risk. Perhaps it already has. The banks have $4.4 trillion foreign assets to offset their liabilities, of course. But what is their real value in this climate?
Britain is not alone in its current distress, although the fall in sterling speaks for itself. The sovereign debt of Russia, Ukraine, Greece, Italy, Belgium, Austria, The Netherlands, Ireland, Australia, New Zealand and Korea is all being tested by the markets. The core of countries deemed safe is shrinking by the day to a half dozen. Sadly, Britain is no longer one of them.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4299883/UK-cannot-take-Icelands-soft-option.html
The British government faces an excruciating choice. It cannot let Royal Bank of Scotland and its fellow mega-banks go to the wall. Yet it risks being swamped by the massive foreign debts of these lenders if it takes on their dollar, euro and yen exposure by opting for full nationalisation.
By Ambrose Evans-PritchardLast Updated: 7:00PM GMT 20 Jan 2009
Comments 0 Comment on this article
Britain has foreign reserves of under $61bn dollars (£43.7bn), less than Malaysia or Thailand. The foreign liabilities of the UK banks are $4.4 trillion – or twice annual GDP – according to the Bank of England. The mismatch is perilous.
It is why sterling has crashed 10 cents from $1.49 to $1.39 against the dollar in two days. The markets have given their verdict on Gordon Brown's latest effort to "save the world".
Credit default swaps (CDS) measuring risk on British debt have reached an all-time high of 125, just below Portugal. The yield spread on 10-year Gilts over German Bunds has doubled to 53 since last week.
Standard & Poor's has quashed rumours that it will soon strip Britain of its AAA credit rating – an indignity averted even after the International Monetary Fund bail-out in 1976. But there was a sting yesterday as it responded to the Treasury plan for the banks. "Market confidence in the sector has eroded to such a degree that it is not clear whether these measures by themselves will bring about a material improvement," the IMF said. "As a result, full nationalisation of some banks remains a possibility in our view."
Spain was relegated from AAA to AA+ on Monday, and Spain's public debt is a much lower share of GDP.
"If Spain can get downgraded, then the risks for the UK are self-evident," said Graham Turner, of GFC Economics. "The increase in the UK gross public debt burden – 11.8 percentage points in just one year – is troubling. The market rightly fears the long-term fiscal costs of a collapsing banking system. Rising Gilt yields are the main impact of the botched move from the UK Treasury."
Mr Turner said the British Government had taken far too long to resort to quantitative easing – printing money – and had wasted months with fiscal frippery as debt deflation throttled the banks.
The parallels with Iceland are disturbing. The country was ruined by the antics of its three big banks. They built up foreign liabilities equal to 900pc of GDP. Operating as hedge funds, they borrowed in dollars, euros and pounds to speculate. However, the state lacked the foreign reserves to match this leverage.
But Iceland at least had the luxury of letting banks default – shifting losses on to the rest of the world. It refused to honour foreign debts.
"They drew a line," said Jerry Rawclifffe, who tracks Iceland for Fitch Ratings. "They created new banks, parking the old losses in resolution committees. It is not easy for other governments to walk away. They have a duty of care."
Indeed, if Britain walked away from UK banks' $4.4 trillion of foreign liabilities – worth eight times Lehman Brothers – it would destroy the credibility of the City and take the whole world into deeper depression.
"The UK cannot go down that route because it would set off an asset price death spiral," said Marc Ostwald, a bond expert at Monument Securities. "The Western banking system is already on life support. That would turn it off altogether."
So whatever the temptations, and whatever the feelings of righteousness over the follies of the RBS leadership in its debt-driven campaign of Napoleonic expansion, the Treasury is wedded to the banks and all their sins. Chancellor Alistair Darling cannot copy Iceland.
S&P's lead UK analyst, Trevor Cullinan, said the Government faces a "severe test" and will be judged by its actions, but he doubts whether matters will reach such a dangerous pass.
"The challenges to UK banks are significant amid a correction in property prices and a contraction of GDP. Nevertheless, the situation is very different from Iceland. The UK benefits from sterling, which is a major global funding currency. UK access to external funding is far more secure. In a worst-case scenario we estimate the cost of recapitalising the UK banking system to be in the region of £83bn (5.7pc of GDP)," he said.
The Government can take out derivatives contracts on currency markets to hedge the foreign debt risk. Perhaps it already has. The banks have $4.4 trillion foreign assets to offset their liabilities, of course. But what is their real value in this climate?
Britain is not alone in its current distress, although the fall in sterling speaks for itself. The sovereign debt of Russia, Ukraine, Greece, Italy, Belgium, Austria, The Netherlands, Ireland, Australia, New Zealand and Korea is all being tested by the markets. The core of countries deemed safe is shrinking by the day to a half dozen. Sadly, Britain is no longer one of them.
http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/4299883/UK-cannot-take-Icelands-soft-option.html
World economy 'close to the bottom' of liquidity cycle
World economy 'close to the bottom' of liquidity cycle
Morgan Stanley has begun to detect early signs that the global economy may be nearing the bottom of the cycle.
By Ambrose Evans-PritchardLast Updated: 9:27PM GMT 18 Jan 2009
It is advising clients to ignore the deep gloom in the markets and focus on deeper fundamental forces as a fresh phase of liquidity gathers strength. However, it is still too early to buy stocks.
"Excess liquidity has started to rise again in the G5 (US, Japan, Germany, Britain and France) for the first time inalmost three years," said Joachim Fels, the US bank's research chief.
"In our view, this marks the beginning of a new global liquidity cycle in 2009. It is driven by unprecedented easing of monetary policy as well as the gradual healing of impaired financial systems."
Dr Fels uses a complex recipe to measure the excess money sloshing through the world's financial system. This is how each long cycle of rising asset prices first builds a foundation.
"As in past episodes, excess liquidity will find its way into asset markets. To some extent, this has already started to happen, with government bond yields having been pushed to new lows, credit spreads coming in and equities having bounced off their lows from last Autumn."
The bank favours corporate credit at this stage rather than government bonds. It likes emerging markets such as the BRICS – Brazil, Russia, India and China – rather than equities in the old world.
Dr Fels says liquidity is the key driver of asset booms and busts. It drove the bond rally in the early 1990s and the dotcom bubble in the late-1990s.
Morgan Stanley said investors must monitor the entire global liquidity picture to understand what is going on in today's cross-border markets.
Teun Draaisma, the bank's European investment guru, said stocks tend to rally roughly six months before the US property market touches bottom in each cycle – although that is not what occurred in the relatively modest housing slide in the early-1930s.
By this measure, it is still too early to take the plunge in the stock markets. His team expects US house prices to keep falling until the middle of 2010, dropping a total of 46pc from peak to trough. They are down 24pc so far.
"Patience is the golden rule in bear markets, and the bigger the crisis, the more patience is required," he said.
http://www.telegraph.co.uk/finance/globalbusiness/4284602/World-economy-close-to-the-bottom-of-liquidity-cycle.html
Morgan Stanley has begun to detect early signs that the global economy may be nearing the bottom of the cycle.
By Ambrose Evans-PritchardLast Updated: 9:27PM GMT 18 Jan 2009
It is advising clients to ignore the deep gloom in the markets and focus on deeper fundamental forces as a fresh phase of liquidity gathers strength. However, it is still too early to buy stocks.
"Excess liquidity has started to rise again in the G5 (US, Japan, Germany, Britain and France) for the first time inalmost three years," said Joachim Fels, the US bank's research chief.
"In our view, this marks the beginning of a new global liquidity cycle in 2009. It is driven by unprecedented easing of monetary policy as well as the gradual healing of impaired financial systems."
Dr Fels uses a complex recipe to measure the excess money sloshing through the world's financial system. This is how each long cycle of rising asset prices first builds a foundation.
"As in past episodes, excess liquidity will find its way into asset markets. To some extent, this has already started to happen, with government bond yields having been pushed to new lows, credit spreads coming in and equities having bounced off their lows from last Autumn."
The bank favours corporate credit at this stage rather than government bonds. It likes emerging markets such as the BRICS – Brazil, Russia, India and China – rather than equities in the old world.
Dr Fels says liquidity is the key driver of asset booms and busts. It drove the bond rally in the early 1990s and the dotcom bubble in the late-1990s.
Morgan Stanley said investors must monitor the entire global liquidity picture to understand what is going on in today's cross-border markets.
Teun Draaisma, the bank's European investment guru, said stocks tend to rally roughly six months before the US property market touches bottom in each cycle – although that is not what occurred in the relatively modest housing slide in the early-1930s.
By this measure, it is still too early to take the plunge in the stock markets. His team expects US house prices to keep falling until the middle of 2010, dropping a total of 46pc from peak to trough. They are down 24pc so far.
"Patience is the golden rule in bear markets, and the bigger the crisis, the more patience is required," he said.
http://www.telegraph.co.uk/finance/globalbusiness/4284602/World-economy-close-to-the-bottom-of-liquidity-cycle.html
Bank of England to buy bonds and loans in first step towards quantitative easing
The iconic columns of the Bank of England in London. Photo: EPABank of England to buy bonds and loans in first step towards quantitative easing
The Government has taken the first step towards quantitative easing by authorising the Bank of England to buy up to £50bn of private sector assets as part of a wider drive to get banks lending again.
By Angela Monaghan Last Updated: 2:52PM GMT 19 Jan 2009
Under the scheme the Bank will be able to buy corporate bonds and consumer loans under the Government's new credit guarantee scheme.
Mervyn King, the Bank's Governor, said the new facility would "provide an important additional tool to improve financing conditions in the economy."
The move is not quantitative easing as it does not involve an increase in the money supply, but some said it could mark the beginning of a shift in that direction.
"This framework could readily evolve into full-blown quantitative easing - we would expect it to do so given the proximity of Bank Rate a de facto zero bound and deteriorating economic conditions, perhaps as soon as March/April," said Ross Walker, economist at Royal Bank of Scotland.
Quantitative easing, also known as printing money, is a more unconventional tool available to the Bank beyond interest rates as it attempts to halt the pace of economic decline in the UK.
The programme announced by the Treasury today comes into effect on February 2, before the next vote on interest rates by the Bank's Monetary Policy Committee on February 5.
"In effect one can argue that this makes the Bank of England the UK's 'bad bank', even if there are some limits to the risk that is being transferred," said Marc Ostwald, strategist at Monument Securities. "Cynics could also argue that Brown and Darling are merely passing the buck to the MPC in terms of exit strategy."
It is part of a broader programme announced by the Treasury this morning allow banks to exchange cash or shares for a Government guarantee on their "toxic" debts. As part of the rescue package, the taxpayer has taken an even bigger stake in Royal Bank of Scotland
The package comes before the first official confirmation on Friday that the UK is in recession. The Office for National Statistics is expected to reveal a sharp decline in gross domestic product in the final quarter of 2008, following a 0.6pc contraction in the third quarter. A technical recession occurs when the economy shrinks for two successive quarters.
What we do when interest rates fail
What we do when interest rates fail
Mervyn King sets out the future for monetary policy, writes Edmund Conway
Last Updated: 8:13PM GMT 20 Jan 2009
You know things have come to a pretty pass when the Bank of England Governor admits that his main tool for influencing the economy – the UK benchmark interest rate – is no longer working.
But that is precisely what Mervyn King did last night. In a remarkable speech, he told Britons for the first time to brace themselves for quantitative easing. His acknowledgement that the UK central bank will have to resort to this drastic new method – used rarely in the history of finance – is likely to go down as one of the landmark moments in the financial crisis.
Equally striking as his confirmation that the Bank may soon embark on a policy of directly pumping cash into the economy was his stark description of the scale of the current malaise. Activity and confidence throughout the global economy had "fallen off a cliff", he said, with shares in London falling at one of the fastest rates in history and exports and output from here to the Far East dropping dramatically.
It is only against such a backdrop that such drastic action is necessary, he said. The plan the Bank intends to follow bears some resemblance to the scheme already in place in the US. The Bank has been granted permission by the Treasury to spend up to £50bn on assets, which it will then keep on its books with a view to selling them off later. The assets, which include commercial bonds and asset-backed securities, will be bought off private investors in the secondary markets – but this time the Bank will give them cash in return for the investments. The result will be an expansion of the Bank's balance sheet. For those who really follow such things, this is not quantitative easing, but what Ben Bernanke recently described as "credit easing".
In Mr King's words, which are worth quoting at length: "The disruption to the banking system has impaired the effectiveness of our conventional interest rate instrument. And with Bank Rate already at its lowest level in the Bank's history, it is sensible for the [Monetary Policy Committee] to prepare for the possibility – and I stress that we are not there yet – that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures.
"They would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies. That should encourage the banking system to expand the supply of broad money by lending to the private sector and also help companies to raise finance from capital markets."
The new asset purchase scheme will in fact give the Bank two powers beyond the ability to expand its own balance sheet. The first is to influence the pricing of a particular species of investment. If it believes the markets for certain corporate bonds are frozen, for instance, it may concentrate on buying them to help improve liquidity.
Second, and perhaps most importantly of all, it can, with the permission of the Treasury, opt to under-fund the Government's budget deficit. This means selling off fewer gilts than is necessary to pay for the assets, and is similar to what Japan did in the late 1990s, and what the Federal Reserve has now moved onto now. This is real quantitative easing. Interestingly, however, Mr King was reticent on how and when such a move would take place. It is hardly surprising. This kind of central bank activity has the potential to be highly inflationary. That should not be an immediate concern, given that the UK is now facing deflation.
http://www.telegraph.co.uk/finance/comment/edmundconway/4299635/What-we-do-when-interest-rates-fail.html
Mervyn King sets out the future for monetary policy, writes Edmund Conway
Last Updated: 8:13PM GMT 20 Jan 2009
You know things have come to a pretty pass when the Bank of England Governor admits that his main tool for influencing the economy – the UK benchmark interest rate – is no longer working.
But that is precisely what Mervyn King did last night. In a remarkable speech, he told Britons for the first time to brace themselves for quantitative easing. His acknowledgement that the UK central bank will have to resort to this drastic new method – used rarely in the history of finance – is likely to go down as one of the landmark moments in the financial crisis.
Equally striking as his confirmation that the Bank may soon embark on a policy of directly pumping cash into the economy was his stark description of the scale of the current malaise. Activity and confidence throughout the global economy had "fallen off a cliff", he said, with shares in London falling at one of the fastest rates in history and exports and output from here to the Far East dropping dramatically.
It is only against such a backdrop that such drastic action is necessary, he said. The plan the Bank intends to follow bears some resemblance to the scheme already in place in the US. The Bank has been granted permission by the Treasury to spend up to £50bn on assets, which it will then keep on its books with a view to selling them off later. The assets, which include commercial bonds and asset-backed securities, will be bought off private investors in the secondary markets – but this time the Bank will give them cash in return for the investments. The result will be an expansion of the Bank's balance sheet. For those who really follow such things, this is not quantitative easing, but what Ben Bernanke recently described as "credit easing".
In Mr King's words, which are worth quoting at length: "The disruption to the banking system has impaired the effectiveness of our conventional interest rate instrument. And with Bank Rate already at its lowest level in the Bank's history, it is sensible for the [Monetary Policy Committee] to prepare for the possibility – and I stress that we are not there yet – that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures.
"They would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies. That should encourage the banking system to expand the supply of broad money by lending to the private sector and also help companies to raise finance from capital markets."
The new asset purchase scheme will in fact give the Bank two powers beyond the ability to expand its own balance sheet. The first is to influence the pricing of a particular species of investment. If it believes the markets for certain corporate bonds are frozen, for instance, it may concentrate on buying them to help improve liquidity.
Second, and perhaps most importantly of all, it can, with the permission of the Treasury, opt to under-fund the Government's budget deficit. This means selling off fewer gilts than is necessary to pay for the assets, and is similar to what Japan did in the late 1990s, and what the Federal Reserve has now moved onto now. This is real quantitative easing. Interestingly, however, Mr King was reticent on how and when such a move would take place. It is hardly surprising. This kind of central bank activity has the potential to be highly inflationary. That should not be an immediate concern, given that the UK is now facing deflation.
http://www.telegraph.co.uk/finance/comment/edmundconway/4299635/What-we-do-when-interest-rates-fail.html
Sterling slumps to eight-year low after second bank bail-out
Sterling slumps to eight-year low after second bank bail-out
Sterling tumbled below the $1.40 mark against the dollar for the first time in almost a decade and fell against the rest of the world's major currencies as the UK Government's second bail-out of the country's banks underlined the dangers facing the economy.
By Angela MonaghanLast Updated: 6:37PM GMT 20 Jan 2009
The pound, which was trading above the $2 mark less than 12 months ago, slumped to below the $1.40 mark for the first time since June 2001 in morning trading in London after registering a fall of more than three cents yesterday.
Currency traders have been aggressively selling the pound as the depth of the recession facing the UK becomes clearer. Interest rates are now at 1.5pc and most analysts expect the Bank of England to continue cutting close to zero in an effort to get money moving around the economy again.
"Sterling has struggled due to the announcement of the new policy measures, in addition to reports of big losses in the UK banking sector," analysts at UBS said this morning.
Analysts are concerned that the second bail-out will substantially increase Britain's debt beyond the 8pc of gross domestic product projected by the Chancellor Alistair Darling at the Pre-Budget Report in November.
Prime Minister Gordon Brown admitted yesterday that he does not know how much the second bail-out of the banks will cost.
Steve Barrow, currency strategist at Standard Bank, predicts that the pound will slide to around $1.35 against the dollar over the next month or two.
He argues that although the US banking system has been hit by similar difficulties to the UK, sterling is particularly vulnerable to a weak performance from the financial sector and banking shares.
"One clear reason for the closer relationship in the UK is that the dollar can act as a safe-haven in times of global stress," he said.
Sterling is now down 28pc against the dollar in the past year and in December sterling teetered on the brink of parity with the euro for the first time.
This morning it tumbled more than 2p to 92.75 and fell to a record low of 124.77 versus the yen.
Jim Rogers, the co-founder of Quantum fund with George Soros, today told Bloomberg News that “I would urge you to sell any sterling you might have.”
http://www.telegraph.co.uk/finance/financetopics/recession/4295391/Sterling-slumps-to-eight-year-low-after-second-bank-bail-out.html
Sterling tumbled below the $1.40 mark against the dollar for the first time in almost a decade and fell against the rest of the world's major currencies as the UK Government's second bail-out of the country's banks underlined the dangers facing the economy.
By Angela MonaghanLast Updated: 6:37PM GMT 20 Jan 2009
The pound, which was trading above the $2 mark less than 12 months ago, slumped to below the $1.40 mark for the first time since June 2001 in morning trading in London after registering a fall of more than three cents yesterday.
Currency traders have been aggressively selling the pound as the depth of the recession facing the UK becomes clearer. Interest rates are now at 1.5pc and most analysts expect the Bank of England to continue cutting close to zero in an effort to get money moving around the economy again.
"Sterling has struggled due to the announcement of the new policy measures, in addition to reports of big losses in the UK banking sector," analysts at UBS said this morning.
Analysts are concerned that the second bail-out will substantially increase Britain's debt beyond the 8pc of gross domestic product projected by the Chancellor Alistair Darling at the Pre-Budget Report in November.
Prime Minister Gordon Brown admitted yesterday that he does not know how much the second bail-out of the banks will cost.
Steve Barrow, currency strategist at Standard Bank, predicts that the pound will slide to around $1.35 against the dollar over the next month or two.
He argues that although the US banking system has been hit by similar difficulties to the UK, sterling is particularly vulnerable to a weak performance from the financial sector and banking shares.
"One clear reason for the closer relationship in the UK is that the dollar can act as a safe-haven in times of global stress," he said.
Sterling is now down 28pc against the dollar in the past year and in December sterling teetered on the brink of parity with the euro for the first time.
This morning it tumbled more than 2p to 92.75 and fell to a record low of 124.77 versus the yen.
Jim Rogers, the co-founder of Quantum fund with George Soros, today told Bloomberg News that “I would urge you to sell any sterling you might have.”
http://www.telegraph.co.uk/finance/financetopics/recession/4295391/Sterling-slumps-to-eight-year-low-after-second-bank-bail-out.html
Tuesday, 20 January 2009
How to Profit From the Credit Crunch
JANUARY 17, 2009, 11:11 P.M. ET
How to Profit From the Credit Crunch
By MARK GONGLOFF
Investors shell-shocked by two nasty bear markets in stocks in less than a decade are starting to look elsewhere for good returns. In the wake of the worst credit crunch since the Great Depression, some analysts suggest they might take a look at, believe it or not, credit.
Their reasoning: Bonds and other credit instruments have arguably suffered much more than stocks during this downturn, meaning they could have further to climb when the economy starts to recover. What's more, as credit led the economy and stocks into the valley, it might have to lead them back out, meaning it could recover before stocks do.
Stocks "are historically first out of the block" in a recovery, says Binky Chadha, chief U.S. equity strategist at Deutsche Bank, "but given the credit crisis this time, credit has to recover before we can get equity returns."
Stocks took several steps back from a recovery last week, when the Dow Jones Industrial Average fell 3.7%. The blue-chip index is down 5.6% so far this year and 42% from its record high in October 2007. Last November, at the depths of the current bear market, the Dow was off 47% from its record, the worst decline since the 1930s.
But the suffering in the credit market has been unprecedented, as investors have come to avoid credit risk like poison. They have demanded record-high interest rates on debt, at levels that suggest a record wave of corporate defaults.
On the bright side, this offers investors a hefty yield -- even after a slight recovery in credit markets in recent weeks, which has pushed interest rates lower.
Many analysts say bonds still offer "equity-like" returns, but that may be underselling them: There is a chance some bonds can offer better returns than stocks.
'Astounding' Yields
For example, the yields on corporate bonds that ratings agencies consider below-investment-grade -- so-called junk bonds -- are 16 percentage points higher, on average, than yields on U.S. government debt of similar duration, according to Merrill Lynch data. A 10-year junk bond might yield 18%, compared with roughly 2% for the 10-year Treasury note.
That is an astounding gap; two years ago, junk bonds yielded just two percentage points more than Treasurys. This "spread" is not much lower than its record high of about 22 percentage points, set in November. Many analysts say this represents a much direr outlook for the economy and corporate bankruptcies than even the stock market does.
"Yield levels and the expected default rates they imply are way out of line with everything but a nuclear bomb," says Vinny Catalano, chief investment strategist at Blue Marble Research.
Safer debts have lower yields, just as more-creditworthy individual borrowers get lower rates when they apply for a loan. Bonds for companies with an "A" credit rating -- roughly middle of the pack for investment-grade bonds -- yield five percentage points more, on average, than Treasurys. Historically the spread is about one point.
Municipal bonds, which state and local governments use to pay for building bridges and libraries, yield nearly one percentage point more than Treasurys. Typically, given the rarity of municipal defaults and the tax-exempt status of their bonds, they yield slightly less than Treasurys.
These safer credit risks don't offer enormous returns, but if the stock market is flat, or worse, in 2009, then they could look much more appetizing. And despite a recent swoon, stocks could still be in store for a big disappointment if the economy fails to rebound sharply in the second half of the year, as many in the stock market still hope. Bonds, on the other hand, may already be priced for big disappointment.
No Certainty for Stocks
"We're really not even close to a point yet where we could state with confidence that equities will significantly outperform corporate bonds over the next six months," says John Lonski, managing director and economist at credit-rating agency Moody's.
But there are risks to wading into debt. If the economy roars back much more quickly than economists expect, bonds would still rally, but stocks might surge even more.
On the other hand, an economy that stays sluggish for a long time could spawn a growing wave of corporate bankruptcies that burn debt holders. What keeps policy makers awake at night is a worry that stimulus measures won't break the vicious cycle gripping the economy right now, in which tight credit hurts the economy, which hurts borrowers' ability to repay their debt and leads to still-tighter credit.
Even assuming some benefit from stimulus, Moody's expects high-yield-debt default rates to surge to 15% by the end of 2009, from just 4% at the end of 2008. That would be a record high for defaults in the modern era of junk bonds, which began in the 1980s.
Investment-grade default rates have been much lower, but will likely rise, as well. An economy that fails to respond to stimulus could push defaults still higher.
Meanwhile, some $758 billion in corporate debt is coming due in 2009, according to Standard & Poor's, meaning companies will have to either pay what they owe or refinance. Most of these debts were incurred five or 10 years ago, when rates were much lower, so refinancing will mean significantly higher borrowing costs for most companies. Less-creditworthy companies may not be able to get new financing at all. This increases the risk that companies won't be able to pay their debts.
In other words, very high yields on corporate bonds may be perfectly appropriate, given the risk that they could turn to dust in your hands. "It is still a very treacherous economic climate, and one has to proceed with caution" when buying debt, says Mr. Lonski.
Write to Mark Gongloff at mark.gongloff@wsj.com
How to Profit From the Credit Crunch
By MARK GONGLOFF
Investors shell-shocked by two nasty bear markets in stocks in less than a decade are starting to look elsewhere for good returns. In the wake of the worst credit crunch since the Great Depression, some analysts suggest they might take a look at, believe it or not, credit.
Their reasoning: Bonds and other credit instruments have arguably suffered much more than stocks during this downturn, meaning they could have further to climb when the economy starts to recover. What's more, as credit led the economy and stocks into the valley, it might have to lead them back out, meaning it could recover before stocks do.
Stocks "are historically first out of the block" in a recovery, says Binky Chadha, chief U.S. equity strategist at Deutsche Bank, "but given the credit crisis this time, credit has to recover before we can get equity returns."
Stocks took several steps back from a recovery last week, when the Dow Jones Industrial Average fell 3.7%. The blue-chip index is down 5.6% so far this year and 42% from its record high in October 2007. Last November, at the depths of the current bear market, the Dow was off 47% from its record, the worst decline since the 1930s.
But the suffering in the credit market has been unprecedented, as investors have come to avoid credit risk like poison. They have demanded record-high interest rates on debt, at levels that suggest a record wave of corporate defaults.
On the bright side, this offers investors a hefty yield -- even after a slight recovery in credit markets in recent weeks, which has pushed interest rates lower.
Many analysts say bonds still offer "equity-like" returns, but that may be underselling them: There is a chance some bonds can offer better returns than stocks.
'Astounding' Yields
For example, the yields on corporate bonds that ratings agencies consider below-investment-grade -- so-called junk bonds -- are 16 percentage points higher, on average, than yields on U.S. government debt of similar duration, according to Merrill Lynch data. A 10-year junk bond might yield 18%, compared with roughly 2% for the 10-year Treasury note.
That is an astounding gap; two years ago, junk bonds yielded just two percentage points more than Treasurys. This "spread" is not much lower than its record high of about 22 percentage points, set in November. Many analysts say this represents a much direr outlook for the economy and corporate bankruptcies than even the stock market does.
"Yield levels and the expected default rates they imply are way out of line with everything but a nuclear bomb," says Vinny Catalano, chief investment strategist at Blue Marble Research.
Safer debts have lower yields, just as more-creditworthy individual borrowers get lower rates when they apply for a loan. Bonds for companies with an "A" credit rating -- roughly middle of the pack for investment-grade bonds -- yield five percentage points more, on average, than Treasurys. Historically the spread is about one point.
Municipal bonds, which state and local governments use to pay for building bridges and libraries, yield nearly one percentage point more than Treasurys. Typically, given the rarity of municipal defaults and the tax-exempt status of their bonds, they yield slightly less than Treasurys.
These safer credit risks don't offer enormous returns, but if the stock market is flat, or worse, in 2009, then they could look much more appetizing. And despite a recent swoon, stocks could still be in store for a big disappointment if the economy fails to rebound sharply in the second half of the year, as many in the stock market still hope. Bonds, on the other hand, may already be priced for big disappointment.
No Certainty for Stocks
"We're really not even close to a point yet where we could state with confidence that equities will significantly outperform corporate bonds over the next six months," says John Lonski, managing director and economist at credit-rating agency Moody's.
But there are risks to wading into debt. If the economy roars back much more quickly than economists expect, bonds would still rally, but stocks might surge even more.
On the other hand, an economy that stays sluggish for a long time could spawn a growing wave of corporate bankruptcies that burn debt holders. What keeps policy makers awake at night is a worry that stimulus measures won't break the vicious cycle gripping the economy right now, in which tight credit hurts the economy, which hurts borrowers' ability to repay their debt and leads to still-tighter credit.
Even assuming some benefit from stimulus, Moody's expects high-yield-debt default rates to surge to 15% by the end of 2009, from just 4% at the end of 2008. That would be a record high for defaults in the modern era of junk bonds, which began in the 1980s.
Investment-grade default rates have been much lower, but will likely rise, as well. An economy that fails to respond to stimulus could push defaults still higher.
Meanwhile, some $758 billion in corporate debt is coming due in 2009, according to Standard & Poor's, meaning companies will have to either pay what they owe or refinance. Most of these debts were incurred five or 10 years ago, when rates were much lower, so refinancing will mean significantly higher borrowing costs for most companies. Less-creditworthy companies may not be able to get new financing at all. This increases the risk that companies won't be able to pay their debts.
In other words, very high yields on corporate bonds may be perfectly appropriate, given the risk that they could turn to dust in your hands. "It is still a very treacherous economic climate, and one has to proceed with caution" when buying debt, says Mr. Lonski.
Write to Mark Gongloff at mark.gongloff@wsj.com
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