Jun

24

If you have read the book Why Stock Markets Crash, the author has a very good section on the growth stock paradox in negative interest rate environments, as originally highlighted by Von Neumann in 1938 when t-bill yields went negative as money fled Europe to get away from Hitler.

Mathematically, anything with a positive yield takes on an infinite value, however, the math allows for two solutions U and - U both balance. When the charge on a magnet changes, there are large effects. The Fed papers call these regimes "Jump Dynamics." QE has created the same environment for carry trades. I believe the Fed has increased the probably of Jump Dynamics. LTCM went about 4 years up Feb 1994- Feb 1998 and was out of business by the end of August. QE turned 4 this past March and since May markets have begun reversing all convergence trades which benefited from QE. Recall gold in Rubles, suddenly revalued in August.

Stocks may stablize yet, as they did the summer of 1987, but yields are moving like they did that year after trading in a low range. the prior year. There were two legs up in rates then.

The long term issue is this — stocks offer a compelling risk premium over cash at 0 as one might estimate them to now offer 6.25%, however, there are many environments in which stocks, in a free market, may offer compelling absolute values of 10-12% which would require a move back toward the lows.

In 1914 the markets made such a move back to the panic lows of 1907 with a six month halt.

Interestingly, book value of the S&P 500 in Barron's this week is 666.97. The Fed lent to AIG on the basis of its book value of $90 Billion at the time, did it also lend to the market based on a 4-5 year projection of book value at that low? I think so, as the bank assets have about a 4-5 life, and in 2009 cash buyers were bidding 30 looking for 20-25% in 4-5 years cash on cash because there was no leverage available, the banks said to the Fed, allow us to earn the equity Return and Bring book values up to our current marks at 70 (for the good banks).

This out of court bankruptcy restructuring of current rates to 0, making no net new loans, and riding equity value up to marks, has taken time, but now looks to be complete.

Where the markets really broken in 2009 or did the leveraged institutions just not like the prices. Market participants are expecting $110 in S&P earnings. This would require a 16% return on equity. A high hurdle for the market as a whole. If one actually checks the data one would see company's currently are earning about 13% in line with historical averages implying about $91 of normalized earnings power.


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