Another Market Crisis? My Survival Manual/Journal!

I would be lying if I said that I like down markets more than up markets, but I have learned to accept the fact that
markets that go up will come down, and that when they do so quickly, you have the makings of a crisis. I find myself
getting more popular during these periods, as acquaintances, friends and relatives that I have not heard from in years
seem to find me. They are invariably disappointed by my inability to forecast the future and my unwillingness to tell
them what to do next, and I am sure that I move several notches down the Guru scale as a consequence, a development
that I welcome. To save myself some repetitions of this already tedious sequence, I think it is best that I pull out my
crisis survival journal/manual, a work in progress that I started in the 1980s and that I revisit and rewrite each time
markets go into a tailspin. It is more journal than manual, more personal than general, and more about me than it is
about markets. So, read on at your own risk!

The Price of Risk

For me, the first casualty in a crisis is perspective, as I find myself getting whipsawed with news stories about financial
markets, each more urgent and demanding of attention than the previous one. The second casualty is common sense,
as my brain shuts down and my primitive impulses take over. Consequently, I find it useful to step back and look at
the big picture, hoping to see patterns that help me make sense of the drivers of market chaos.

It is my view that the key number in understanding any market crisis is the price of risk. In a market crisis, the price
of risk increases abruptly, causing the value of all risky assets to drop, with that drop being greater for riskier assets.
While the conventional wisdom, prior to 2008, was that the price of risk in mature markets is stable and does not
change much over short periods, the last quarter of 2008 changed (or should have changed) that view. I started tracking
the price of risk in different markets (equity, bond, real estate) on a monthly basis in September 2008, a practice that
I have continued through the present. Getting an a forward-looking, dynamic price of risk in the bond market is simple,
since it takes the form of default spreads on bonds, and FRED (the immensely useful Federal Reserve Database) has
the market interest rates on a Baa rated (Moody's) bonds going back to 1919, with data available in annual, monthly
or daily increments. That default spread is computed by taking the difference between this market interest rate and the
US treasury bond rate on the same date. Getting a forward-looking, dynamic price of risk in the equity markets is
more complicated, since the expected cash flows are uncertain (unlike coupons on bonds) and equities don't have a
specific maturity date, but I have argued that it can be done, though some may take issue with my approach. Starting
with the cumulative cash flow that would have generated by investing in stocks in the most recent twelve months, I
estimate expected cash flows (using analysts' top down estimates of earnings growth) and compute the rate of return
that is embedded in the current level of the index. That internal rate of return is the expected return on stocks and when
the US treasury bond rate is netted out, it yields an implied equity risk premium. The January 2015 equity risk premium
is summarized below:

Implied ERP Spreadsheet (January 2015)

That premium had not moved much for most of this year, with a low of 5.67% on March 1, and a high of 6.01% in
early February, and the ERP at the start of August was 5.90%, close to the start-of-the-year number. Given the market
turmoil in the last weeks, I decided to go back and compute the implied equity risk premium each day, starting on
August 1.
 ERP By Day

Note that not much changes until August 17, and that almost all of the movement have been in the days between
August 17 and August 245 During those seven trading days, the S&P 500 dropped by more than 11% and if you keep
cash flows fixed, the expected return (IRR) for stocks increased by 0.68%. During the same period, the US treasury
bond rate dropped by 0.06%, playing its usual "flight to safety" role, and the implied equity risk premium (ERP)
jumped by 0.74% to 6.56%.

I did use the trailing 12-month cash flows (from buybacks and dividends) as my base year number, in computing these
equity risk premiums, and there is a reasonable argument to be made that these cash flows are too high to sustain,
partly because earnings are at historic highs and partly because companies are returning more of that cash than ever
before. To counter this problem, I assumed that earnings would drop back to a level that reflects the average earnings
over the last 10 years, adjusted for inflation (i.e., the denominator in the Shiller CAPE model) and that the payout
would revert back to the average payout over the last decade. That results in lower equity risk premiums, but the last
few days have pushed that premium up by 0.53% as well.

My computed increases in ERP, using both trailing and normalized earnings, overstate the true change, because the
cash flows and growth were left at what they were at the start of August, a patently unrealistic assumption, since this
is also an economic crisis, and any slowing of growth in China will make itself felt on the earnings, cash flows and
growth at US companies. That effect will take a while to show up, as corporate earnings, buyback plans and analyst
growth estimates are adjusted in the months to come, and I am sure that some of the market drop was caused by
changes in fundamentals. The argument that a large portion of the drop comes from the repricing of risk is borne out
by the rise in the default spread for bonds, with the Baa default spread widening by 0.17%, and the increase in the
perceived riskiness (volatility) of stocks, with the VIX posting its largest weekly jump ever, in percentage terms.

The Repricing of Risky Assets

When the price of risk changes, all risky assets will be repriced, but not by the same magnitude. Within mature markets,
you should expect to see a bigger drop in stock prices at more risky companies than at safer ones, though how you
define risk can affect your conclusions. If you define risk as exposure to the the precipitating factor in the crisis, I
would expect the stock prices of companies that are more dependent on China for their revenues to drop by more than
the rest of the market. Since I don't have data on how much revenue individual companies get from China, I will use
commodity companies, which have been aided the most by the Chinese growth machine over the last decade and
therefore have the most to lose from it slowing down, as my proxy for China exposure. The table below highlights the
20 industry groups (out of 95) that have performed the worst between August 14 and August 24:
Notice that commodity companies comprise one quarter of the group, with a few cyclical and technology sectors
thrown into the mix.

Looking across markets geographically, changes in the equity risk premium in mature markets will be magnified as
you move into riskier countries and thus it is not surprising to see the carnage in emerging markets over the last week
has exceeded that in developed markets, with currency declines adding to local stock market drops.

Percentage Return in US dollar terms

In the picture below, I capture the percentage change in market capitalizations between August 14, 2015,
and August 24, 2015 in U.S. $ terms, with the PE ratios as of August 14 and August 24 highlighted for each
country:

via chartsbin.com
Note that this phenomenon of emerging markets behaving badly cannot be blamed on China, since it happened in
2008 as well, when it was the banking system in developed markets that triggered the market rout.

A Premium for Liquidity?

There is another dimension, where crises come into play, and that is in the demand for liquidity. While investors
always prefer more liquid assets to less liquid ones, that preference for liquidity and the price that they are willing to
pay for it varies across time and tends to surge during market crisis. To see if this crisis has had the same effect, I
looked at the drop in market capitalization, in US $ terms, between August 14 and 24 for companies classified by
trading turnover ratios (computed by dividing the annual dollar trading value by the market capitalization of the
company):

Liquidity classes, based on turnover ratio = $ Trading Value/ $ Market Cap

Surprisingly, it is the most liquid firms that have seen the biggest drop in stock prices, though the numbers may be
contaminated by the fact that trading halts are often the reactions to market crises in many countries, that are home to
the least liquid stocks. If this is the reason for the return divergence, there is more pain waiting for investors in these
stocks as the market drop shows up in lagged returns.
To the extent that market crises crimp access to capital markets, the desire for liquidity can also reach deeper into
corporate balance sheets, creating premiums for companies that have substantial cash on their balance sheets and fewer
debt obligations. To test this proposition, I classified firms globally, based upon the net debt as a percent of enterprise
value, and looked at the price drop between August 14 and August 24:

Net Debt/EV = (Total Debt- Cash)/ (Debt + Market Cap - Cash)

The crisis seems to have spared no group of stocks, with the pain divided almost evenly across the net debt classes,
with the largest price decline being in the stocks that have cash balances that exceed their debt. Note, however, that
the multiples at which these companies trade at both prior and after the drop, reflect the penalty that the market is
attaching to extreme leverage, with the most levered companies trading at a PE ratio of 3.11 (at least across the 15.76%
of firms in this group that have positive earnings to report). If your contrarian strategy for this market is to screen for
and buy low PE stocks, this table suggests caution, since a large portion of the lowest PE stocks will come with high
debt ratios.

As the public markets drop, the question of how this crisis will affect private company valuations has risen to the
surface, especially given the large valuations commanded by some private companies. Since many of these private
businesses are young, risky startups and that investments in them are illiquid, I would guess they will be exposed to a
correction, larger than what we observe in the public marketplace. However, given that venture capitalists and public
investors in these companies will be self appraising the value of their holdings, the effect of any markdown in value
will take the form of fewer high-profile deals (IPO and VC financing).

What now?
A market crisis bring out my worst instincts as an investor. First out of the pack is fear pushing me to panic, with the
voice yelling "Sell everything, sell it now", getting louder with each bad market day. That is followed quickly
by denial, where another voice tells me that if I don't check the damage to my portfolio, perhaps it has been magically
unaffected. Then, a combination of greed and hubris kicks in, arguing that the market is filled with naive, uninformed
investors and that this is my time to trade my way to quick profits. I cannot make these instincts go away, but I have
my own set of rules for managing them. (I am not suggesting that these are rules that you should adopt, just that they
work for me..)
1. Break the feedback loop: Being able to check your portfolio as often as you want and in real time,
with our phones, tablets and computers, is a mixed blessing. I did check my portfolio this morning for the
damage that the last week has done, but I don't plan to check again until the end of the week. If I find myself
breaking this rule, I will consider sabotaging my wifi connection at home, going back to a flip phone or
leaving for the Galapagos on vacation.
2. Turn off the noise: I read the Wall Street Journal and Financial Times each morning, but I generally
don't watch financial news channels or visit financial websites. I become religious about this avoidance
during market chaos, since much of the advice that I will get is bad, most of the analysis is after-the-fact
navel gazing and all of the predictions share only one quality, which is that they will be wrong.
3. Rediscover your faith: In my book (and class) on investment philosophies, I argue that there is no
"best' investment philosophy that works for all investors but that there is one for you, that best fits what you
believe about markets and your personality. My investment philosophy is built on faith in two premises, that
every business has a value that I can estimate, and that the market price will move towards that value over
time. During a crisis, I find myself returning to the core of that philosophy, to make sense of what is going
on.
4. Act proactively and consistently: It is natural to want to act in response to a crisis. I am no exception
and I did act on Monday, but I tried to do so consistently with my philosophy. I revisited the valuations that
I have done over the past year (and you can find most of them on my website, under my valuation class) and
put in limit buy orders on a half a dozen stocks (including Apple, Tesla and Facebook), with the limit prices
based on my valuations of the companies. If the crisis eases, none of the limit orders may go through, but I
would have protected myself from impulsive actions that will cost me more in the long term. If it worsens,
 all or most of the of the limit buys will be executed, but at prices that I think are reasonable, given the cash
flow potential of these companies.
Will any of these protect me from losing money? Perhaps not, but I did sleep well last night and am more worried
about whether the New York Yankees will score some runs tonight than I am about what the Asian markets will do
overnight. That, to me, is a sign of health!
The Silver Linings
Just as recessions are a market economy's way of cleansing itself of excesses that build up during boom periods, a
market crisis is a financial market's mechanism for getting back into balance. I know that is small consolation for you
today, if you have lost 10% or more of your portfolio, but there are seedlings of good news, even in the dreary financial
news:
1. Live by momentum, die by it: In trading, momentum is king and investors who play the
momentum game make money with ease, but with one caveat. When momentum shifts, the easy profits
accumulated over months and years can be wiped out quickly, as commodity and currency traders are
discovering.
2. Deal or no deal? If you share my view that slowing down in M&A deals is bad news for deal makers,
but good news for stockholders in the deal-making companies, the fact that this crisis may be imperiling
deals is positive news.
3. Rediscover fundamentals: My belief that first principles and fundamentals ultimately win out and
that there are no easy ways to make money is strengthened when I read that carry traders are losing money,
that currency pegs do not work when inflation rates deviate, and mismatching the currencies in which you
borrow and generate cash flows is a bad idea.
4. The Market Guru Handoff: As with prior crises, this one will unmask a lot of economic forecasters
and market gurus as fakes, but it will anoint a new group of prognosticators who got the China call right as
the new stars of the investment universe.
If a market crisis is a crucible that tests both the limits of my investment philosophy and my faith in it, I am being
tested and as with any other test, if I pass it, I will come out stronger for the experience. At least, that is what I tell
myself as I look at the withered remains of my investments in Vale and Lukoil!

Spreadsheets
1. Implied Equity Risk Premium Spreadsheet (August 2015)
2. Returns (8/14-8/24) and PE ratios (before & after), by Industry Group
3. Returns (8/14-8/24) and PE ratios (before & after), by Country

Posted by Aswath Damodaran at 11:28 AM 9 comments: Links to this post

Labels: Investment Philosophy, Market Crisis, Market Timing

Wednesday, August 15, 2018

Deja Vu In Turkey: Currency Crisis and Corporate Insanity!

This has been a year of rolling crises, some originating in developed markets and some in emerging markets, and the
market has been remarkably resilient through all of them. It is now Turkey's turn to be in the limelight, though not in
a way it hoped to be, as the Turkish Lira enters what seems like a death spiral, that threatens to spill over into other
emerging markets. There is plenty that can be said about the macro origins of this crisis, with Turkey's leaders and
central bank bearing a lion's share of the blame, but that is not going to be the focus of this post. Instead, I would like
to examine how Turkish business practices, and the willful ignorance of basic financial first principles, are making
the effects of this crisis worse, and perhaps even catastrophic.

The Turkish Crisis: So far!

The Turkish problem became a full fledged crisis towards the end of last week, but this is a crisis that has been brewing
for months, if not years. It has its roots in both Turkish politics and dysfunctional practices on the part of Turkish
regulators, banks and businesses, and has been aided and abetted by investors who have been too willing to look the
other way. The most visible symbol of this crisis has been the collapse of the Turkish Lira, which has been losing
value, relative to other currencies, for a while, capped off by a drop of almost 15% last Friday (August 10):
 Yahoo! Finance

While it is undoubtedly true that the weaker Lira will lead to more problems, currency collapses are symptoms of
fundamental problems and for Turkey, those problems are two fold. One is a surge in inflation in the Turkish economy,
which can be seen in graph below:

While it easy to blame the Turkish central bank for dereliction of duty, it has been handicapped by Turkey's political
leadership, which seems intent on making its own central bank toothless. Rather than allow the central bank to use the
classic counter to a currency collapse of raising central bank-set interest rates, the government has put pressure on the
bank to lower rates, with predictable (and disastrous) consequences.

Corporate Finance: First Principles

I teach both corporate finance and valuation, and while both are built on the same first principles, corporate finance is
both wider and deeper than valuation since it looks at businesses from the inside out. i.e., how decisions made a firm's
founders/managers play out in value. In my introductory corporate finance class, I list out the three common sense
principles that govern all businesses and how they drive value:
The financing principle operates at the nexus of investing and dividend principles and choices you make on financing
can affect both investment and dividend policy. It is true that when most analysts look at the financing principle, they
zero in on the financing mix part, looking at the right mix of debt and equity for a firm. I have posted on that question
many times, including the start of this year as part of my examination of global debt ratios, and have used the tools to
assess whether a company should borrow money or use equity (See my posts on Tesla and Valeant). There is another
part to the financing principle, though, that is often ignored, and it is that the right debt for a company should mirror
its asset characteristics. Put simply, long term projects should be funded with long term debt, convertible debt is a
better choice than fixed rate debt for growth companies and assets with cash flows in dollars (euros) should be funded
with dollar (euro) debt. The intuition behind matching does not require elaborate mathematical reasoning but is built
on common sense. When you mismatch debt (in terms of maturity, type or currency) with assets, you increase your
likelihood of default, and holding debt ratios constant, your cost of debt and capital.

In effect, your perfect debt will provide you with all of the tax benefits of debt while behaving like equity, with cash
flows that adapt to your cash flows from operations.

There are two ways that you can match debt up to assets. The first is to issue debt that is reflective of your projects
and assets and the second is to use derivatives and swaps to fix the mismatch. Thus, a company that gets its cash flows
in rupees, but has dollar debt, can use currency futures and options to protect itself, at least partially, against currency
movements. While access to derivatives and swap markets has increased over time, a company that knows its long
term project characteristics should issue debt that matches that long term exposure, and then use derivatives & swaps
to protect itself against short term variations in exposure.

Turkey: A Debt Mismatch Outlier?

The argument for matching debt structure (maturity, currency, convertibility) to asset characteristics is not rocket-
science but corporations around the world seem to revel in mismatching debt and assets, using short term debt to fund
long term assets (or vice versa) and sometimes debt in one currency to fund projects that generate cashflows in another.
In numerous studies, done over the decades, looking across countries, Turkish companies rank among the very worst,
when it comes to mismatching currencies on debt, using foreign currency debt (Euros and dollars primarily) to fund
domestic investments.

Lest I be accused of using foreign data services that are biased against Turkey, I decided to stick with the data provided
by the Turkish Central Bank on the currency breakdown of borrowings by Turkish firms. In the chart below, I trace
the foreign exchange (FX) assets and liabilities, for non-financial Turkish companies, from 2008 and 2018:

Central Bank of Turkey

The numbers are staggeringly out of sync with Turkish non-financial service companies owing $217 billion more in
foreign currency terms than they own on foreign currency assets, and this imbalance (between foreign exchange assets
and liabilities) has widened over time, tripling since 2008.

I am sure that there will be some in the Turkish business establishment who will blame the mismatching on external
forces, with banks in other European countries playing the role of villains, but the numbers tell a different story. Much
of the FX debt has come from Turkish banks, not German or French banks, as can be seen in the chart below:
 Central Bank of Turkey

In 2018, 59% of all FX liabilities at Turkish non-financial service firms came from Turkish banks and financial service
firms, up from 39% in 2008. The mismatch is not just on currencies, though. Looking at the breakdown, by maturity,
of FX assets and liabilities for Turkish non-financial service firms, here is what we see:

Central Bank of Turkey

In May 2018, while about 80% of FX assets are Turkish non-financial firms are short term, only 27% of the FX debt
is short term, a large temporal imbalance.

It is possible that the Turkish government may be able to put pressure on domestic banks to prevent them from forcing
debt payments, in the face of the collapse of the lira, but looking at when the debt owed foreign borrowers comes due
(for both Turkish financial and non-financial firms), here is what we see.

Central Bank of Turkey

From a default risk perspective, though, the debt maturity schedule carries a message. About 50% of debt owed by
Turkish banks and 40% of the debt owed by Turkish non-financial service companies will be coming due by 2020,
and if the precipitous drop in the Lira is not reversed, there is a whole lot of pain in store for these firms.

Rationalizing the Mismatch: The Good, The Dangerous and the Deadly
Turkish firms clearly have a debt mismatch problem, and the institutions (government, bank regulators, banks) that
should have been keeping the problem in check seem to have played an active role in making it worse. Worse, this is
not the first time that Turkish firms and banks will be working through a debt mismatch crisis. It has happened before,
in 1994, 2001 and 2008, just looking at recent decades. If insanity is doing the same thing over and over, expecting a
different outcome, there is a good case to be made that Turkish institutions, from top to bottom, are insane, at least
when it comes to dealing with currency in financing. So, why do Turkish companies seem willing to repeat this mistake
over and over again? In fact, since this mismatching seems to occur in many emerging markets, though to a lesser
scale, why do companies go for currency mismatches? Having heard the rationalizations from dozens of CFOs on
every continent, I would classify the reasons on a spectrum from acceptable to absurd.

Acceptable Reasons
There are three scenarios where a company may choose to mismatch debt, borrowing in a currency other than the one
in which it gets its cash flows.
1. The mismatched debt is subsidized: If the mismatched debt is being offered to you (the borrower)
at rates that are well below what you should be paying, given your default risk, you should accept that
mismatched debt. That is sometimes the case when companies get funding from organizations like the IFC
that offer the subsidies in the interests of meeting other objectives (such as increasing investment in under
developed countries). It can also happen when lenders and bondholders become overly optimistic about an
emerging market's prospects, and lend money on the assumption that high growth will continue without
hiccups.
2. Domestic debt markets are moribund: There are emerging markets where the only option for
borrowing money is local banks, and during periods of uncertainty or crisis, these banks can pull back from
lending. If you are a company in one of these markets and have the option of borrowing elsewhere in the
world to fund what you believe are good investments, you may push forward with your borrowing, even
though it is currency mismatched.
3. Domestic debt markets are too rigid: As you can see from the debt design section, the perfect debt
for your firm will often require tweaks that include not only conversion and floating rate options, but more
unusual tweaks (such as commodity-linked interest rates). If domestic debt markets are unwilling or unable
to offer these customized debt offerings, a company that can access bond markets overseas may do so, even
if it means borrowing in a mismatched currency.
In all three cases, though, once the money has been borrowed, the company that has mismatched its debt should turn
to the derivatives and swap markets to reduce or eliminate this mismatch.

Dangerous Reasons
There are two reasons that are offered by some companies that mismatch debt that may make sense, on the surface,
but are inherently dangerous:

1. Speculate on currency: Mismatching currencies, when you borrow money, can be a profitable
exercise, if the currency moves in the right direction. A Turkish company that borrows in US dollars, a lower-
inflation currency with lower interest rates, to fund projects that deliver cashflows in Turkish Lira, a higher-
inflation currency, will book profits if the Lira strengthens against the US dollar. Since emerging market
currencies can go through extended periods of deviation from purchasing power parity, i.e., the higher
inflation emerging market currency strengthens (rather than weakening) against the lower inflation developed
market currency, mismatching currencies can be profitable for extended periods. There will be a moment of
reckoning, in the longer term, though, when exchange rates will correct, and unless the company can see this
moment coming and correct its mismatch, it will not only lose all of the easy profits from prior periods, but
find its survival threatened. Currency forecasting is a pointless exercise, even when practiced by professional
currency traders, and I think that companies should steer away from the practice.
2. Everyone does it: I have argued that many corporate finance practices are driven by inertia and me-
tooism rather than good sense, and in many countries where currency mismatches are common, the standard
defense is that everyone does it. Many of these companies argue that the government cannot let the entire
corporate sector slide into default and will step in to bail them out, and true to form, governments deliver
those bailouts. In effect, the taxpayers become the backstop for bad corporate behavior.
Bad Reasons
I am surprised by some of the arguments that I have heard for mismatching debt, since they suggest fundamental gaps
in basic financial and economic knowledge.

1. The mismatched debt has a lower interest rate: I have heard CFOs of companies in emerging
markets, where domestic debt carries high interest rates, argue that it is cheaper to borrow in US dollars or
Euros, because interest rates are lower on loans denominated in those currencies. After all, it is cheaper to
borrow at 5% than at 15%, right? Not necessarily, if the 5% rate is on a US dollar debt and the 15% debt is
in Turkish Lira, and here is why. If the expected inflation rate in US dollars is 2% and in Turkish Lira is 14%,
it is the Turkish Lira debt that is cheaper.
2. Risk/Reward: There are some companies that fall back on the proposition that mismatching debt is
like any other financial choice, a trade off between higher risk and higher reward. In other words, their belief
is that they will earn higher profits, on average and over time, with mismatched debt than with matched debt,
but with more variability in those profits. This argument stems from the misplaced belief that markets reward
all risk taking, when the truth is that senseless risk taking just delivers more risk, with no reward, and
mismatching debt is senseless.
The Fix
It is too late for Turkish companies to fix their debt problem for this crisis, but given that this crisis too shall pass,
albeit after substantial damage has been done, there are actions that we can take to keep it from repeating, though it
will require everyone involved to change their ways:
 Governments should stop enabling debt mismatching, by not stepping in repeatedly to save corporates that
have mismatched debt. That will increase the short term pain of the next crisis, but reduce the likelihood of repeating
that crisis.
 Bank Regulators should measure how much the banks that they regulate have lent out to corporates, in
mismatched debt, and require them to set aside more capital to cover the inevitable losses. That, in turn, will reduce
the profitability of lending out money to companies that mismatch.
 Banks have to incorporate whether the debt being taken by a business is mismatched in deciding how much
to lend and on what terms. The interest rates on mismatched debt should be higher than on matched debt.
 Companies and businesses have to consider what currency a loan or bond is in, when evaluating interest
rates, and in their own best interests, try to match up debt to assets, either directly (in debt design) or using derivatives.
 Investors in companies should start breaking down the profitability of firms with mismatched debt, especially
in good periods, into profits from debt mismatch and profits from operations, and ignore or at least discount the former,
when pricing these companies.
I don't think any of these changes will happen overnight but unless we change our behavior, we are designed to replay
this crisis in other emerging markets repeatedly.

YouTube Video

Data

1. FX Assets & Liabilities of Turkish non-financial corporations (from Turkish Central Bank)
2. Loans from Abroad to Turkish Private Sector

Papers

1. Financing Innovations and Capital Structure Choices

Posted by Aswath Damodaran at 4:39 PM 5 comments: Links to this post
Labels: Corporate Finance, Country Risk, Financing Principle

Saturday, January 9, 2010

Reversal in Risk Premiums (or premia): The 2010 story

The big story from the 2010 updates is that that risk premiums across the board have reversed the rise that we saw
during the crisis. The broad based nature of the shift can be seen by looking at the following:

a. Equity Risk Premiums: I have been tracking the equity risk premium at the start of every month since the start of
the market crisis on September 12, 2008. On that day, the equity risk premium for the US was 4.37%. That number
exploded to almost 8% in November 2008 and settled in at 6.43% at the start of 2009. In the first three months of
2009, the equity risk premium continued to rise (to more than 7% in early April 2009). Since then, though, the
equity risk premium has dropped dramatically. On January 1, 2010, the equity risk premium was down to 4.36%,
roughly where it was at the start of the crisis. If you are interested in the computation, download the excel
spreadsheet that I used (and feel free to modify and adapt it as you see fit)

b. Bond default spreads: The market crisis had its origins in easy lending, reflected in the low default spreads that
we saw for different bond ratings classes in late 2007. Bond default spreads almost tripled during 2008, thus
outstripping the change you saw in equity risk premiums. In 2009, however, bond default spreads returned to pre-
crisis levels. You can get to my latest estimates of default spreads by clicking here.

c. Sovereign spreads: When the market crisis unfolded, emerging markets were affected more adversely than
developed markets, as manifested in collapsing stock prices and soaring sovereign default spreads. The default
spread for Brazil in the Credit Default Swap mark rose to 7% in November 2008. Those spreads have decreased to
pre-crisis levels (and below, for some markets). Brazil's CDS spread in January 2010 was hovering at about 1.5%.

While I am not surprised that risk premiums have come down, I am surprised at how quickly they have reverted
back to old levels. In early 2009, my prediction would have been that equity risk premiums by the end of the year
would be down to about 5%. At one level, the speedy recovery in risk premiums can be considered to be evidence of
mean reversion- that markets quickly revert back to historic norms even after major crisis. At another level, the
quick adjustment can be viewed as a sign of a market that is in denial. My gut feeling is that the market has gone up
too far, too fast and that equity risk premiums will correct themselves over this year and move back up towards 5%,
but I may very well be wrong again.
Posted by Aswath Damodaran at 11:20 AM 7 comments: Links to this post

Thursday, March 28, 2013

A Sweet Spot for US Equities: Opportunity and Dangers

The US equity markets are on a roll. Today, the S&P 500 hit an all time high, just weeks after the Dow
also broke its record. While it has been less than five years since the crisis of 2008 and the epic collapse
of equities in the last quarter of that year, the returns earned by those who stayed the course, even
relative to pre-crisis price levels, is a testimonial to the dangers of staying out of equity markets for
extended periods. As with every other market surge, this one has brought with it the usual questions:
Have stocks gone up too far, too fast? Are we due for a correction? Should we stay in the market or take
profits? I could cop out and use the excuse that I am not a market timer, but that would be a lie. All
investor are market timers, with the differences being one of degree. So, the honest truth is that I have a
view about markets but that it does not dominate my investment decision process.

Since it is so easy to be swayed by story telling, when talking about equity markets, I try to bring the same
tools to assessing markets that I do for individual stocks. The intrinsic value of equities, in the aggregate,
is determined by four variables:

1. Cash returned to equity investors: Ultimately, we buy stocks to get cash flows in return,
with those cash flows evolving over the last three decades from almost entirely dividends to a mix
of dividends and stock buybacks. Holding all else constant, the more cash that is returned to
investors in the near term, the more you will be willing to pay for stocks.
2. Expected growth: The bonus of investing in equity, as opposed to fixed income, is that
you get to share in the growth that occurs in earnings and cash flows in future periods. Other
things held equal, the higher the expected growth in earnings and expected cash flows, the
higher stock prices should be.
 3. Risk free rate: The risk free rate operates as more than base from which you build
expected returns as investors. It also represents what you would earn from investing in a
guaranteed (or at least as close as you can get to guaranteed) investment instead of
stocks. Consequently, stock prices should increase as the risk free rate decreases, if you hold all
else fixed.
4. Risk premium: Equities are risky and investors will demand a “premium” for investing in
stocks. This premium will be shaped by investor perceptions of the macro economic risk that they
face from investing in stocks. If the equity risk premium is the receptacle for all of the fears and
hopes that equity investors have about the future, the lower that premium, the more they will be
willing to pay for stocks.
Note that while it is easy to focus on each of these variables and draw conclusions about the impact on
stock prices, they tend to move at the same time and often pull in different directions. For instance,
stronger economic growth will push up earnings growth but interest rates will usually go up as well. In a
similar vein, paying out more in cash flows to investors in the current period will often mean less being
invested into businesses and lower growth in the future. It is the trade off that determines whether stock
prices will go up or down as a consequence. On each of these variables, the US equity market is looking
at "good" numbers right now: the cash returned to investors by US companies has rebounded strongly
from post-crisis lows, earnings growth is reasonable, the risk free rate is at a historic low and the equity
risk premium, while not quite at pre-crisis levels, has declined significantly over the last year. To explore
both where we are and the potential dangers that we face as investors, let’s take a look at each variable.

1. Cash flows
a. Background: Until the early 1980s, the primary source of cash flows to equity investors in the United
States was dividends. As I noted in this post from a while back, US companies have increasingly turned
to returning cash in the form of buybacks. While there are some strict value investors who believe that
dividends are qualitatively better than buybacks, because they are less volatile, the aggregate amount
returned by US companies in buybacks is too large to be ignored.

Over the last decade, buybacks have been more volatile than dividends but the bulk of the cash flows
returned to stockholders has come in buybacks.
b. Level: In the most recent twelve months for which data is available (through December 2012), the
companies in the S&P 500 bought back almost $400 billion worth of stock, much more than the $270
billion that they paid out in dividends. In terms of index units and as a percent of the level of the index, the
aggregate cash flows have recovered fully from their post-2008 swoon.
c. Sustainability: While it is good that cash flows are bouncing back, we should worry about whether
companies were over reaching and paying out too much in 2012, perhaps in advance of the fiscal cliff at
the end of 2012, in which case you should expect to see a drop off in cash flows in the near term. There
are three reasons to believe that this is not the case. First, as Birinyi Associates notes in this blog post,
the pace of buybacks is increasing in 2013, not dropping off, with the buybacks authorized in February
2013 at an all-time high. Second, the cash returned in 2012 may have been a historic high in dollar value
terms, but as a percent of the index, it is close to the average yield over the last decade. Third, the
aggregate cash balances at the S&P 500 company amounted to 10.66% of firm value at the end of 2012,
suggesting that companies have cash on hand to sustain and perhaps even increase cash returned to
stockholders. While a portion of this cash is trapped, it is possible that corporate tax reform, if it happens,
will release this cash for distribution to stockholders.

2. Expected growth
a. Background: For dividends and buybacks to continue to grow in the future, there has to be growth in
earnings. While that growth can be estimated by looking at history or by tracking analyst forecasts of
earnings for the individual companies, it has to be earned by companies, reinvesting their earnings back
into operations and generating a healthy return on equity on those investments.
Intrinsic growth rate = Equity Reinvestment Rate * Return on equity
Thus, while history can sometimes yield skewed values (up or down) on growth and analysts can become
overly optimistic or pessimistic, the intrinsic growth rate will be grounded in reality.
b. Level: To look at earnings growth in the S&P 500, lets begin by looking at history. In the table below,
we report on earnings growth rates over 5 years, 10 years, 20 years and 50 years in index earnings.

Arithmetic average Geometric Average

Last 5 years 6.46% 4.42%
Last 10 years 9.66% 8.33%
Last 20 years 9.60% 8.28%
Last 50 years 8.30% 6.90%
Over the last 5 years, the compounded average annual growth rate in aggregate earnings for the S&P
500 has been 4.42%. As the most widely followed index in the world, analyst estimates of growth in
earnings are widely available both for individual companies in the S&P 500 index and for aggregate
earnings in the index. Using the former to construct a bottom-up estimate of growth yields 10.57% as the
expected growth rate in March 2013. Since there is evidence that analyst estimates of growth are biased
upwards at the company level, we also looked at the “top down” estimates of growth that analysts are
forecasting for aggregate earnings in March 2013, obtaining a lower growth rate of 5.33% a year for the
next 5 years.
c. Sustainability: Are analysts over estimating earnings growth? One way to check is to compute the
intrinsic growth rate by computing the equity reinvestment rate and return on equity for the index. To
compute the equity reinvestment rate, we use the aggregate cash returned to investors (75.31) in 2012
and the earnings on the S&P 500 (102.47) in 2012:
Equity Reinvestment Rate = 1 - 75.31/102.47 = 26.51%
To compute the return on equity on the index, we divide the aggregate earnings on the index in 2012 by
the aggregate book value of equity on the index (613.14) at the start of 2012:
Return on equity = 102.47/613.14 = 16.71%
The product of the two yields a sustainable growth rate:
Sustainable growth rate = .2651 * .1671 = .0443 or 4.43%
While this number is lower than the top-down analyst estimate of growth, it is within shouting distance of
the estimate. There is, of course, a concern that some investors and analysts have voiced about the
operating earnings number reported for the S&P 500, arguing that it is over stated. If it is, then the equity
reinvestment rate and ROE are both over stated, and the expected growth rate will be lower.
3. Equity Risk Premium (ERP)
a. Background: Put simply, the equity risk premium is the market price of equity risk. It is determined on
the one hand by perceptions of the macro risk that surround investors, with greater risks going with a
higher ERP, and on the other hand by the collective risk aversion of investors, with more risk aversion
translating into a larger ERP. A larger ERP implies that investors will pay lower prices for the same set of
equity cash flows. The conventional wisdom that this number is stable in mature markets was shaken by
the banking crisis of 2008, as premiums in the US and European equity markets experienced
unprecedented volatility.
b. Level: There are two ways in which ERP can be estimated. One is to look at a long period of history
and to estimate the premium that stocks would have generated, over an above the treasury bond rate,
over that period. This “historical” premium approach yields 4.20% as the ERP for US stocks in 2013,
using data from 1928-2012. The other is to estimate an “implied” premium, by backing out an internal rate
of return from current stock prices and expected cash flows. This approach yields much more volatile
equity risk premiums over time, as can be seen in the graph below:

The implied ERP at the start of 2013 was 5.78%, lower than the ERP at the start of 2012, but still at the
high end of the historical range.
c. Sustainability: I have been estimating the monthly ERP for the S&P 500 since September 2008, and as
can be seen in the figure below, the premium of 5.43% at the start of March 2013 represents a significant
decline from a year ago. Note, though, that it is still much higher than the premium that prevailed in
September 2008, just prior to the crisis. In fact, the average implied ERP over the last decade has been
4.71%, lower than the current implied ERP.
[I have an long, not-very-fun update that I do on equity risk premiums that you can download and peruse,
if you are so inclined. It includes everything that I know about ERP]

4. Risk free rate

a. Background: As sovereigns increasingly face default risk, it is an open question whether any
investment is risk free in today’s environment. However, for an investor in US dollars, the return you can
expect to make on a long term treasury bond not only represents a base from which all other expected
returns are computed but is an opportunity cost of investing in something risk free instead of stocks.
b. Level: By any measure, risk free rates are at historic lows in much of the developed world. On March
26, 2013, the ten-year US Treasury bond rate was at 1.91%, well below where it stood prior to the last
quarter of 2008 and well below rates that prevailed a decade earlier.
The average for the ten year bond rate for the last decade was 3.59% and lengthening the time period
pushes the average up to 4.62% (last 20 years) and 6.58% (last 50 years)
c. Sustainability: Is the treasury bond rate destined to rise and if it does, will it bring down stocks? To
answer this question, we have to look at what has kept rates low for such an extended period. While the
answer to some is that it is the Fed’s doing, I, for one, don’t attribute that much power to Ben Bernanke.
The Fed has played a role, but it has succeeded (if you can call it success) only because inflation has
been benign and real economic growth has been abysmal for this period. There are at least four
scenarios that I see for the future direction of interest rates, with differing implications for stocks.

Scenario Treasury bond rate Outlook for stocks

More of the same (anemic
economic growth, low
inflation)
Stronger economic growth,
low inflation
Low economic growth,
high inflation
Higher economic growth,
low inflation, Fed Magic
Stays low Neutral
Rises to reflect higher real If economic growth
growth translates into earnings
growth, neutral. If not,
mildly negative.
Rises to reflect higher Negative. Higher required
inflation returns on stocks, no
offsetting positive.
Stays low Positive

If you believe that the Fed can keep a lid on interest rates, as economic growth returns, the outlook is
positive for stocks. I think that the most likely scenario is that the interest rates will rise as the economy
improved, and the outlook for stocks will depend in large part on whether earnings growth picks up
enough to offset the interest rate effect.

Valuation of the S&P 500 Index

To see the interplay of these numbers and the resulting consequences for stocks, I valued the S&P 500,
as of March 26, 2013, using the following inputs:
Based upon my assumptions, the market’s current winning ways can be justified. Replacing the current
implied equity risk premium with the average premium over the last decade (4.71%) yields a level of
almost 1800 for the index, and using the analyst-estimated growth rate will make it even higher. Higher
risk free rates have a negative, albeit muted, effect on value, if accompanied by higher growth rates, but
do have a much more negative impact, if growth rates remain unchanged. You may have very different
views on the market drivers and if you are interested, you can input your numbers into the attached
spreadsheet to get an assessment of value for the S&P 500 index.

Bottom line
When stocks hit new highs, the natural impulse is to look for signs of over valuation, but there are good
reasons why US stock prices are elevated: cash flows are high, growth looks good, the macro risks seem
to have faded (at least some what) and the alternatives are delivering lousy returns. In the near term,
stocks remain vulnerable to two possibilities. One is that another macro crisis will pop up (Italy, Spain,
Portugal or a non-EU black sheet) that will cause equity risk premiums to jump back to the 6%+ levels
that we have seen so often in the last 5 years. The other is a sudden surge in interest rates,
unaccompanied by better earnings or higher earnings growth. Since all risky asset classes (corporate
bonds, real estate etc.) will be also adversely affected by either of these developments, I don't see much
point to shifting from equities to other risky assets to protect myself against these risks. I could, of course,
choose to stay in cash, but as the last 5 years have indicated, waiting for the "right time" to invest can
leave you on the sidelines for too long. So, I am going to stop worrying about the overall market and go
back to finding under valued companies.