Posted: February 26th, 2023
please see attached
3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times
Uncertainty created in the wake of the pandemic has been reflected in stock markets with a rise in volatility © AP
Michael Mauboussin FEBRUARY 9 2021
The writer is a researcher at Morgan Stanley Investment Management
The year 2020 will forever be associated with Covid-19 and the ills it caused to people and economies around the world.
The outbreak of the pandemic led to the greatest contraction in global economic activity in decades and a precipitous fall in stock markets. More surprising to most was the extent of the sharp rally from March lows.
The interplay of two forces that drive valuations, the cost of capital and the volatility of markets, might explain some of that counterintuitive behaviour.
The cost of capital represents the return investors demand for owning a security and therefore determines a company’s cost of debt and equity funding. Volatility in markets captures uncertainty about the future.
Opinion Markets Insight
How the parting of two market forces helped spur the equity rally
Volatility boosts value of companies with options to invest in future projects
please summarize the below in 7-8 sentences.https://www.ft.com/stream/47f86556-93f8-4a4f-a0be-ce430ace8348 https://www.ft.com/markets/insight https://www.ft.com/stream/47f86556-93f8-4a4f-a0be-ce430ace8348 JRDUMAS Highlight 3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times
Quite sensibly, the cost of capital and volatility almost always move in lockstep because investors require a higher expected return when the world looks riskier. But in 2020, the cost of capital and volatility went in opposite directions.
When the price of many stocks and bonds plunged, central bankers referred to a playbook created during the 2008 financial crisis. Prescribed actions included lowering interest rates, purchasing securities on the open market, lending to businesses on favourable terms and providing households with money to ease their burdens.
These actions had the effect of lowering the cost of capital. The cost of equity component of this is commonly calculated as the sum of a risk-free rate of return and the equity risk premium (the extra return investors require for owning stocks).
The yield on the US 10-year Treasury note is a proxy for the risk-free rate and went from 1.9 per cent at the beginning of 2020 to 0.9 per cent at the end. Aswath Damodaran, a professor and valuation expert, estimates that the equity risk premium dropped from 5.2 to 4.7 per cent over the same period as the rebound in stock prices implied lower future returns. The yields on corporate bonds followed a similar trajectory.3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times
These figures imply that the cost of equity declined from 7.1 to 5.6 per cent during the year. When used in valuation calculations, this boosts the current worth of expected future earnings of companies as the future income stream is discounted at a lower rate.
Companies therefore received a richer valuation on greater current or prospective earnings. Companies that gained from trends
arising from the pandemic, such as those that enabled working from home, particularly benefited.
However, while the actions of the central banks relieved financial pain, they did little to dissipate uncertainty. Open questions include the timing and strength of the economic recovery, which businesses will be the ultimate winners and losers, and the degree to which consumer behaviour has changed permanently.
The uncertainty has been reflected in stock markets with a rise in volatility. This is captured by the Cboe volatility index, or Vix. The Vix started 2020 at about 14 but averaged 30 for the full year. The ratio of the Vix to the cost of equity averaged around two from 2016-2019 but soared to five in 2020. This matters because volatility is a primary driver of option value.
An option is the right, but not the obligation, to do something. Financial options have been around for a very long time. In recent decades, economists have also developed the concept of real options. These represent the value of a company’s right to make real investments in projects such as expansion into a new line of business.
While the actions of the central banks relieved financial pain, they did little to dissipate uncertainty3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times
Copyright The Financial Times Limited 2021. All rights reserved.
High volatility means the potential worth of projects falls in a wide range. There’s no obligation to act on an option if value is low, but there is a right to act if value is high. Certain businesses are rich with real options. Think of Amazon 20 years ago.
In 2020, companies with real options had a valuation boost for their current operations because of a fall in the cost of capital and a gain in their real options because of an increase in volatility. These observations are also consistent with the performance of convertible bonds, securities that combine a stream of cash flows and an option to convert into equity. The Bloomberg Barclays US Convertibles Liquid Bond Index rose 54 per cent in 2020.
This might help explain some of the large stock price movements in the past year, particularly in the tech sector. The cost of capital and volatility are likely to converge as we pass through this episode. But the pandemic caused actions and reactions with remarkable implications for valuation.http://help.ft.com/help/legal-privacy/copyright/copyright-policy/
Place an order in 3 easy steps. Takes less than 5 mins.