Why Equities will Follow the Debt Meltdown

While the turmoil in the debt markets is set to continue, despite the passage of the bailout package, Wall Street analysts are now busy making the case for equities. There are unique buying opportunities out there today, is a classic refrain in the television and print media. Really? Wilful blindness or plain old-fashioned ignorance?

What these self-styled experts would have you believe is that there is a fundamental disconnect between debt and equity. But anybody who has run a business knows that, at their roots, both instruments emanate from the same value drivers: in the briefest of terms, under a logically constructed business model, the impact of the same valuation premises which are attributed to equity must form the basis for debt pricing.

Whatever happened to the concept of weighted average cost of capital, essentially incorporating equity, debt and hybrids? Well, for the present, the concept itself has been discarded, perhaps conveniently, and for very obvious reasons.

Firstly, those in control of the marketplace have succeeded in largely under-pricing debt and over-pricing equities since the late 1980s. Secondly, there is a widespread reluctance to recognize that quoted share prices, which are conditioned by options, shorts, futures, day-trading and leverage, over and above the credibility of business models, are not an adequate reflection of inherent risks.

Finally, corporate balance sheets prepared under existing regulatory regimes are incapable of disclosing whether debt service compliance and dividend capability is actually being generated by the core components of a business model or by residual surpluses from debenture or share issuances.

The assessment of risk, moreover, is severely constrained, in a qualitative manner, by the failure to understand the global economy on one hand and by the dynamics shaping the fate of the poor countries on the other. For instance, the economic reality of the developing world (where both fascism and despotism are on the rise) is that real family incomes are declining and growth numbers are being artificially fuelled by credit and government spending; the prism of the so-called tiger economies is now turning out to be an illusion.

For instance, given the substantial recourse to offshore jurisdictions of convenience in the previous two decades, the full material facts pertaining to international asset and cash transfer mechanisms are simply not on the table. For instance, western analysts are devoid of the perspective needed to grasp the true impact on the international matrix of the surge in underground wealth, driven by tax evasion and systemic criminal activity throughout the third world.

Which brings us to the critical question of the day: If risk spreads on debt have risen by 35-50% in recent weeks, where are equities headed?

In the same context, it is important to draw the distinction between market capitalization and verifiable corporate value. For far too long, spin masters have collectively succeeded in ensuring that the gap between perception and reality is skewed heavily in favour of the former. But, this time around, the ground has shifted, in more than one respect.

Hopefully, retail investors will realize that professional players on Wall Street are already arbitraging between the spreads on debt and the price of equity, by insisting on significant dilution when granting bailouts.

While Washington lawmakers fret about what is going to happen next, knowledgeable hedge fund and capital pool mangers are already engaged in re-pricing assets right across the spectrum; the deals concluded on Goldman Sachs and General Electric by Warren Buffet are useful examples in this regard.

As far as the impact of the bailout package is concerned, there is one key indicator which will assist you in cutting through the thick fog to be created by an excess of information through next week: the spread between 3-month US treasuries and 3-month LIBOR (London Interbank Offered Rate), commonly called the TED spread by inter-bank traders.

That LIBOR-against-treasury differential, priced well over 3.80% yesterday, is perhaps the best indicator of the crisis within the credit markets.

Since US treasuries are considered risk free and LIBOR reflects the interest rate for borrowings by commercial banks, the TED spread is generally acknowledged as the best mirror of perceptions of default risk on bank-to-bank loans. To place default risk in perspective, the TED spread averaged less than 0.50% through this decade, until the start of the US economic downturn around this time last year. It does not take a genius to figure out who is ultimately bearing the costs, as if higher energy and food prices were not enough.

About the author:
Rakesh Saxena is a pricing and risk analysis specialist in insurance and derivative products and has extensive deal making in the emerging economies. He can be reached at derivatives@shaw.ca. Home URL: www.quoteplatform.com

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