The Bond and Stock MarketsSlide 2Slide 3P-E ratios are now driven by the bond market Given the explosion of interest rates during the 1970s, bonds are no longer viewed as being significantly less risky than stocks:“Irrational Exuberance” in U.S. financial markets? The Context of Fed Chairman Greenspan’s Remarks:My Answer Given to the Fed:S&P 500 Earnings Yields vs Interest RatesCompeting investment yields over the past 125 years reveal a “sea-change” in 1980-81The Risk of Owning Bonds: An Increasingly Different View After 1940Competing Investment Yields10-year Bond Yield: 1980-2000What Drives Bond Yields? In the Longer-Term, Lower Federal Deficits Bring Lower Bond YieldsSlide 13Slide 14Riding the 1990s Rising TideThen, with an Overheating Economy, Interest Rates Began to Rise But Share Prices Didn’t ReactSlide 17Internet ValuationNew Economy Stocks Follow Strange RulesProfile of 30 Recently IPO-ed Internet CompaniesInternet vs. Dow Financial PerformancePrice/Sales Ratios by Internet Sub-GroupInternet Valuation Methodologies Market Capitalization / Revenue ModelLottery Ticket ValuationInternet Valuation Methodologies Internet Market Capitalization / Revenue ModelValuation Methodologies Market Capitalization / Revenue ModelValue Drivers of Publicly Trading Internet Companies Main Findings From Statistical AnalysisSlide 2801/14/19 09:44 AM902cdreb12-ppt 1The Bond and Stock MarketsLecture 19The Bond and Stock MarketsA bond or a share of stock is an ownership right to a stream of future income-A bond offers a fixed set of interest payments and a fixed principal repayment at its maturity. The credit worthiness of the borrower is critical.-A share of stock is literally a proportional ownership of a corporation. But it does not guarantee payment of any dividend (the optional, stock equivalent of a regular interest payment) or repayment of the original purchase price, ever. Once a company sells shares to the public, it is never obligated to buy them back; a seller must find his/her own buyer at any time and any market price. A corporation generates income but may opt not to pay any dividends, reinvesting instead in new corporate projects. Therefore, the only return a shareholder may receive is the price received from another buyer.The Bond and Stock Markets-Investors must choose between these two alternative “long term-oriented” investments. Some common terminology can be applied.-The yield on a bond is the interest payment relative to the purchase price. This yield is paid in cash regularly (e.g. annually) and.the investor must independently reinvest the cash.-The “yield” on stock is less well-defined. The corporation’s board of directors has the right to choose any dividend and to change this payment at any time. Like a bond interest payment, a dividend must be reinvested by the investor. Any current income of the corporation that is not paid as a dividend is retained earnings; these retained earnings are reinvested by the firm in new equipment or product development.A bond or a share of stock is an ownership right to a stream of future incomeP-E ratios are now driven by the bond marketGiven the explosion of interest rates during the 1970s, bonds are no longer viewed as being significantly less risky than stocks:-Bonds have a double inflation risk, while equity investment buys ownership of real assets producing earnings that rise with inflation-This change of attitude, plus greater arbitrage, has produced a new, consistent pattern: the E-P ratio tends to trade just under two percentage points below the 10-year US Treasury bond yield-Expected inflation should be added to the “earnings yield” or E-P ratio to get a comparable return relative to the bond yield. This expected inflation is greater than the observed differential of 1.7% on average, thus a small risk premium is still demanded of stock-A warning: this rule-of-thumb is now widely used, but not widely understood. Permanently lower inflation should narrow the spread between nominal bond yields and earnings-price ratiosIn December 1996, the U.S. Federal Reserve Board asked the Outside Consultants Panel of experts:In December 1996, the U.S. Federal Reserve Board asked the Outside Consultants Panel of experts:“Irrational Exuberance” in U.S. financial markets? The Context of Fed Chairman Greenspan’s Remarks:-“How do you perceive current levels of equity valuation?”-“Are there signs of speculative excess? “My Answer Given to the Fed:-The stock market is not overvalued today (i.e. December 1996): prices have just caught up with earnings, and low bond yields justify a high price-earnings ratio-In the long-run, fundamentals of supply and demand for national and global savings dominate the markets: eliminating the US government deficits would chop yields by a full percentage point0%2%4%6%8%10%12%14%16%1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000SpreadEarnings/Price Ratio10-Year Bond RateThe E/P ratio = the equity yield to be compared to the bond interest rate or yield. Investors have come to recognize that bonds and stocks are both risky investments, and their competing yields should have a normal spread. Therefore the equity bull market of the last two decades has been powerfully driven by declining bond yields.S&P 500 Earnings Yields vs Interest RatesPercentSpread: Bonds-Earnings10-yr Bond YieldEarnings-Price RatioThe earnings-price ratio tracks the bond yield The bond yield averages 1.75% above the earnings-price yieldThe earnings-price ratio tracks the bond yield The bond yield averages 1.75% above the earnings-price yieldCompeting investment yields over the past 125 years reveal a “sea-change” in 1980-81Percent of Total-15%-10%-5%0%5%10%15%20%1871 1891 1911 1931 1951 1971 1991SpreadEarnings/Price Ratio10-Year BondBond - Earnings SpreadEarnings/Price RatioBond Yield0%2%4%6%8%10%12%14%16%1871187918871895190319111919192719351943195119591967197519831991The Risk of Owning Bonds: An Increasingly Different View After 19401871 1940 1974 1982BondYieldPercent of Total10-Year BondCompeting Investment Yields1872-1940 1941-1974 1975-1981 1982-1996Investment in Bonds10-Year Bond YieldAnnual Gain (loss)Total ReturnInvestment in StocksDividend YieldAnnual Gain (loss)Total Return4.3%2.0%6.3%3.9%3.3%7.3%3.9%-3.0%0.9%4.2%7.2%11.4%9.5%-8.0%1.5%4.8%6.4%11.2%8.7%6.1%14.8%3.5%11.5%15.1%0%2%4%6%8%10%12%14%16%1980 1982 1984 1986 1988 1990 1992 1994 1996 1998Percent10-yr Bond YieldBond
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