Vol. 2, No. 11
Vol. 2, No. 11
On the cost of capital; Don't bail out luna investors; Monetary contraction is underway; Is there value in a British bakery chain?
Valuabl is an independent, value-oriented journal of financial markets. Delivered fortnightly, Valuabl helps investors pop bubbles, buy low, and sell high.
In today’s issue
Cartoon: The luna rich list, 2022
The cost of capital (6 minutes)
A global stocktake (3 minutes)
Lunatics should pay the price (8 minutes)
Corporate shuffleboard (4 minutes)
Credit creation, cause & effects (11 minutes)
Investment ideas (16 minutes)
"The source of every speculative mania, besides corruptingly low interest rates, is the drive to do too much with too little. "
—Walter Bagehot, 1870
Cartoon: The luna rich list, 2022
The cost of capital
Interest rates and capital costs are the most consequential yet misunderstood prices in capitalism, connecting the future to the present.
•••
Fears about the state of the global economy have shaken financial markets. In the past few months, stock markets in rich countries have fallen by more than a tenth. The price of risky assets, particularly tech stocks and cryptocurrencies, has been socked the hardest. Inflation is persistently high. It's in double-digits in Brazil, Russia, and Turkey, and almost there in the United States and United Kingdom. Economists continue to downgrade forecasts for economic growth.
Peering out amongst this slew of negative headlines, investors wouldn't be amiss to assume that stock markets were collapsing; they're not. Stock prices climbed last fortnight. The S&P500, an index of large American companies, rose by 1.1%, while the market value of all public companies worldwide rose by $1.8trn (see: 'A global stocktake'). The index is down 16% since January, its peak, and is off 5% over the last year.
As stock prices rose, so too did government bonds. Yields, which move inversely to prices, fell as inflation expectations lessened. The yield on ten-year Treasury bonds, a key rate for valuing financial assets, fell by 15bp. The real interest rate, the difference between yields and expected inflation, remained above zero after arriving there earlier in the month.
Bond investors can expect to increase their purchasing power by 0.2% per year. This bland return doesn't inspire one to rush off and lend to the government, but it does mark a dramatic change from this time last year when creditors were, in effect, paying to borrow.
The equity risk premium (ERP), the extra return investors need to buy stocks instead of bonds, rose by a single basis point. The current premium, 5.5%, is the highest since May 2020, when the COVID-19 pandemic roiled financial markets and is higher than the average over the last five years, 5.09%. It rose 140bp over the previous year, demonstrating how skewiff risk pricing had become.
The cost of equity, the average return equity investors demand to part with their money, is 8.25%. This is down 5bp from last fortnight when Valuabl last went to press and is consistent with the levels investors expected in the past decade.
Creditors also marked up risk. Corporate bonds fell more than government ones as corporate spreads, the difference between yields on business and government bonds, widened. Spreads at the risky end rose more than the safe but, on average, increased by 30bp. Concerns about rising rates colliding with recessions make creditors to levered and crappy firms nervous. These businesses will be the most in need of liquidity, but they will be least likely to get it. If a recession is inbound, consumers and bankers will tighten their belts, and inferior companies will suffocate.
Using the average ERP of the last five years, the current ten-year Treasury bond yield, analysts' consensus earnings estimates, and a stable payout ratio based on the S&P500's average return on equity over the last decade, I value the index at 4,303 compared to its level of 3,979.
This valuation suggests the S&P500 index is 8% undervalued compared to 9% overvalued at the start of the year and 20% overvalued last year.
The mismatch between the numbers and the mood emanating from the investors in speculative assets is palpable. Despair has replaced elation. ‘To the gallows,’ has replaced, ‘to the moon.’ Bosses and investors readily ignore fundamentals during a boom, but when the tide goes out, and the players are left licking their wounds, they point fingers and seek retribution. Luna, the not-so-stablecoin, was likely a fraud (see: ‘Lunatics should pay the price’). Other sticky shams will be revealed as the market correction shines a light into the dank corners of our capital markets.
Stock prices have come down but are about where they should be. Investors who believe the market has collapsed are mistaken; instead, they took on too much risk and had misguided expectations. Victims of fraud will want compensation and demand regulation. They should get it, but lawmakers and courts should ensure the right people pay. Getting this wrong would trivialise our monetary system and force us to take another collective step into the moral hazard swamp.
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