Monday, May 30, 2011
Stocks and Bonds Together
There is no surprising that the rising stock market has since been held in conjunction with the rise of the bonds, the yield of government bonds to 10 years back from 4% to 3.50%.
In my opinion, the phenomenon is rather healthy. It is true that in times of intense crisis, we see the fall of actions coincide with the rise of the bonds, in a movement of flight to quality. This divergence implies then a very strong rise in the risk premium on equities.
In an assessment of market shares made by discounting future cash flows, the relevant discount rate is the rate "risk free" government bonds plus the risk premium on the market. This means that the increase of joint stocks and bonds is reflected, side actions, lower the discount rate as a result of lower risk-free rate. Looking back a little, we know that rising stock between 1995 and 1999 could be largely explained by lower bond yields during this period.
In recent months, there was again a decline in risk premium, which can be read for example in the course of corporate CDS and in reducing the implied volatilities of options and that improved earnings expectations.
Decrease the risk free rate, reducing the risk premium, higher earnings forecasts: These three elements combine to explain the current rally in equities.
Whether it goes well in the optimism is that another story.