Tuesday, January 10, 2012

Risk-on, Risk-off

If the Chicago Board of Options Exchange (CBOE) Volatility Index is any indication, investors in the U.S. equity markets have let go their worst fears in our future.  The index has moderated down to the low 20s in recent weeks after spiking to the high 40s in each of the last two years, a level which while well above averages seemed tolerable compared to record high volatility indications set in 2008 and 2009.

However, major U.S. equity market indices continue to surge upward one day only to plunge by equal or greater amounts the following day.  The almost daily vacillation by investors between accepting risk and then shunning it, has not only given financial media pundits a new catch-phrase  -  “risk-on, risk-off”  -  it suggests a continued wariness in our economic fortunes.    

Which is the better read?  the volatility index or the up and down daily trading roller coaster?  The answer is open to considerable discussion.  I decided to try another tack by pulling one of the Federal Reserve’s oldest tricks out of the bag  -  the Fed Model.

I have mentioned the Fed Model in this column before.  It is a simple comparison of the earnings yield of the S&P 500 and the 10-year U.S. Treasury note yield.  A ratio of 1.0 suggests “fair valuation” in the Fed world.  If the equity earnings yield is greater than the U.S. Treasury yield, stocks are considered overvalued.  Presently that comparison is a 7.69% earnings yield on the S&P 500 (through the September 2011 quarter) to a 0.0179% yield on the 10-Year U.S. Treasury note (0.0769 / 0.0179 = 4.30).

The fact apparently does not bother good folks at the Federal Reserve that bonds and stocks, and therefore their respective yields, are not comparable.  Bonds after all have a certain payment stream and a pay-off date, while equity an indeterminate future payoff.  Some have proposed putting the two in a better comparison by using an inflation indexed 10-year Treasury yield.  At the present time that sits at a negative 0.21%, making stocks look even more overvalued. 

Even with this nuance I am not convinced that stock yields should ever be as low as long-term bond yields in order to fully compensate investors for the risk associated with equity ownership.  Indeed, some use the difference between the two yields rather than the ratio to determine the equity risk premium.  This approach implies a current equity risk premium of 5.9% (0.0769 – 0.0179 = 0.059).

There is an alternative way to look at the disparity between government bond yields and equity yields. Perhaps bonds yields simply do not fully reflect risks in the fixed income market.  The government has intervened with two rounds of quantitative easing and has used a variety of other methods to rejuvenate the credit market.  The usual reactions to and acceptance of risk are out the window  -  risk-on? risk-off? Wait a day and I will let you know.

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