Download The Factors that Drive Expected Returns and Risks

Board of Visitors
October 27, 2001
Duke University
Financial Valuation in a
Time of Crisis
Campbell R. Harvey
Duke University, Durham, NC USA
National Bureau of Economic Research, Cambridge, MA USA
http://www.duke.edu/~charvey
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
1
1. Plan
•
•
•
•
Financial impact
Understanding the financial impact
Current valuations
International linkages
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
2
2. Financial impact
Billions
U.S. Market Capitalization through October 24, 2001
15000
14000
13000
12000
11000
10000
9000
8000
9
0
9
0
1
9
0
0
1
-9 g- 99 ct-9 c-9 b-0 r- 00 n-0 g- 00 ct-0 c-0 b-0 r- 01 n-0 g- 01
n
Ju Au
O De Fe Ap Ju Au
O De Fe Ap Ju Au
Copyright 2001. Campbell R. Harvey.
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3
2. Financial impact
U.S. Market Capitalization September and October 2001
11000
10,104
10000
9,937
9500
9000
8500
8000
1-Sep
3-Sep
5-Sep
7-Sep
9-Sep
11-Sep
13-Sep
15-Sep
17-Sep
19-Sep
21-Sep
23-Sep
25-Sep
27-Sep
29-Sep
1-Oct
3-Oct
5-Oct
7-Oct
9-Oct
11-Oct
13-Oct
15-Oct
17-Oct
19-Oct
21-Oct
23-Oct
Billions
10500
Loss of $167 billion
Copyright 2001. Campbell R. Harvey.
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4
3. Understanding the financial impact
• Understanding stock market reaction
– Three factors:
• Expectations of earnings growth (GDP growth) (+)
• Expectations of risk premium (-)
• Expectations of interest rates (-)
Copyright 2001. Campbell R. Harvey.
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5
3. Understanding the financial impact
• Understanding stock market reaction
– Expectations of earnings growth (GDP growth)
• Higher growth is good for stock values
• Value long-term growth, not necessarily short-term
Most expect slightly slower long-term growth, almost
everyone expects a recession.
Copyright 2001. Campbell R. Harvey.
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6
3. Understanding the financial impact
• Understanding stock market reaction
– Expectations of risk premium
• What expected returns do you require to buy stocks
(relative to bonds)?
• What is the expected return a project must earn in
order for a corporation to approve it?
Risk premium tied to risk. It is hard to argue that we
are in a less risky environment.
Copyright 2001. Campbell R. Harvey.
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7
3. Understanding the financial impact
• Understanding stock market reaction
– Expectations of interest rates
• Higher interest rates mean that future cash flows are
worth less
• For equities, long-term interest rates are very
important.
Short-term rates have dropped dramatically. However,
long term rates have fallen very modestly.
Copyright 2001. Campbell R. Harvey.
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8
4. Sources of impact: Growth
• U.S. annual real GDP growth before crisis:
–
–
–
–
–
–
–
2001Q2 +0.3%
2001Q3 -0.4%
2001Q4 +0.2%
2002Q1 +0.7%
2002Q2 +1.2%
2002Q3 +1.9%
2002Q4 +2.5%
Copyright 2001. Campbell R. Harvey.
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9
4. Sources of impact: Growth
• U.S. annual real GDP growth after crisis:
–
–
–
–
–
–
–
2001Q2 +0.3%
2001Q3 -0.8%
2001Q4 -2.0%
2002Q1 -0.7%
2002Q2 -0.2%
2002Q3 +1.0%
2002Q4 +2.8%
Copyright 2001. Campbell R. Harvey.
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10
4. Sources of impact: Growth
GDP Before and After Crisis
Real Annual GDP Growth
0.04
$165 billion loss
0.03
0.02
0.01
2001Q2
Before
After
0
-0.01
1
2
3
4
5
6
7
-0.02
-0.03
Copyright 2001. Campbell R. Harvey.
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11
4. Sources of impact: Growth
• Income effect
– U.S. GDP $165 billion
– Other countries GDP $250 billion
– Total = $415 billion (conservative)
• Growth effect
– Loss of 0.1% from growth prospects
Copyright 2001. Campbell R. Harvey.
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12
4. Sources of impact: Risk
• Risk premium
– Graham-Harvey survey of CFOs was running
during the crisis
– Before and after crisis comparison
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13
4. Sources of impact: Risk
• Risk premium
– 10-year risk premium increases across pre-post
samples
– Comparing Sept. 10 to Sept. 12, 3.6% vs 4.8%
• 1.2% increase in mean risk premium
Copyright 2001. Campbell R. Harvey.
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4. Sources of impact: Risk
• Risk premium
– holding everything else equal, a 1.2% increase
would imply a large loss in stock market value
Copyright 2001. Campbell R. Harvey.
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15
4. Sources of impact: Risk
• Why does risk premium increase?
– Market volatility as measured by
“disagreement” increases (which should
increase the premium)
– Fundamental risk has increased
Copyright 2001. Campbell R. Harvey.
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16
4. Sources of impact: Risk
Returns and Institutional Investor Country Credit
Ratings from 1990
Average returns
0.5
0.4
R2 = 0.2976
0.3
0.2
0.1
0
-0.1 0
20
40
60
80
100
Rating
Lower rating (higher risk) commands higher expected returns.
Copyright 2001. Campbell R. Harvey.
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17
4. Sources of impact: Rates
U.S. Interest Rates
5
10-year
4.5
3.5
3
3-month
2.5
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
10/19/01
10/12/01
10/5/01
9/28/01
9/21/01
9/14/01
9/7/01
2
8/31/01
Yields
4
18
4. Sources of impact: Rates
Corporate and Mortgage Rates
8.5
8.3
8.1
7.7
7.5
7.3
7.1
6.9
6.7
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
10/19/01
10/12/01
10/5/01
9/28/01
9/21/01
9/14/01
9/7/01
6.5
8/31/01
Yields
7.9
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4. Sources of impact: Interpretation
• What is the interpretation?
– While interest rates have gone down slightly,
risk premium has increased and expected
growth lower
– Implication: Lower valuations
Copyright 2001. Campbell R. Harvey.
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20
5. Valuation
• We have started from very high valuations
– PE ratio is currently 27 (September 2001)
– Aside from 1998-2000, highest level since 1929
– 98th percentile! [See Cliff Asness, “A Brief
Essay On Current Stock Market Valuation, and
the Bubble That Has Shrunk, But Not Died”]
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
21
5. Valuation
S&P 500 Trailing P/E Ratio
40
35
30
25
20
15
10
5
0
1
1
1
1
1
1
1
1
1
1
1
1
1
1
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
1
1
1
1
1
1
1
1
1
1
1
1
1
1
7
8
9
0
1
2
3
4
5
6
7
8
9
0
18
18
18
19
19
19
19
19
19
19
19
19
19
20
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
22
5. Valuation
S&P 500 10-yr Moving AverageTrailing P/E Ratio
50
40
30
20
10
0
1
1
1
1
1
1
1
1
1
1
1
1
1
1
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
1
1
1
1
1
1
1
1
1
1
1
1
1
1
7
8
9
0
1
2
3
4
5
6
7
8
9
0
18
18
18
19
19
19
19
19
19
19
19
19
19
20
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
23
5. Valuation
S&P 500 Maximal Real Trailing P/E Ratio
40
35
30
25
20
15
10
5
0
1
1
1
1
1
1
1
1
1
1
1
1
1
1
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
1
1
1
1
1
1
1
1
1
1
1
1
1
1
7
8
9
0
1
2
3
4
5
6
7
8
9
0
18
18
18
19
19
19
19
19
19
19
19
19
19
20
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
24
5. Valuation
S&P 500 Payout Ratio
180.0%
160.0%
140.0%
120.0%
100.0%
80.0%
60.0%
40.0%
20.0%
0.0%
1
1
1
1
1
1
1
1
1
1
1
1
1
1
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
:0
1
1
1
1
1
1
1
1
1
1
1
1
1
1
7
8
9
0
1
2
3
4
5
6
7
8
9
0
18
18
18
19
19
19
19
19
19
19
19
19
19
20
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
25
5. Valuation
• Back of the envelope calculations
– Assume
• Payout=80%; Risk Premium=4.8%; Long-term
interest rate=4.5%; Real growth=2.7%;
Inflation=2.5%
• Model implies a PE ratio of 19.5
• Model implies drop in market of 28%
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
26
5. Valuation
• Back of the envelope calculations
– Assume (sensitivity analysis)
• Payout=80%; Risk Premium=4.1%; Long-term
interest rate=4.5%; Real growth=2.7%;
Inflation=2.5%
• Model implies a PE ratio of 23.5
• Model implies drop in market of 13%
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
27
6. International impact
• World economic linkages
– World economy is critically linked to health of
the U.S. economy
Copyright 2001. Campbell R. Harvey.
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28
6. International impact
Average Monthly Returns in %
3
2
1
0
-1
-2
-3
U.S. Contraction
Data through
Sept 2001
W
O
US
UK
CH
SE
ES
SG
NO
NZ
NL
JP
IT
EI
HK
DE
FR
FI
DK
CA
BE
AT
AU
-4
U.S. Expansion
Copyright 2001. Campbell R. Harvey.
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29
6. International impact
Average Monthly Standard Deviation of Returns in %
14
12
10
8
6
4
2
U.S. Contraction
Data through
Sept 2001
W
O
US
UK
CH
SE
ES
SG
NO
NZ
NL
JP
IT
EI
HK
DE
FR
FI
DK
CA
BE
AT
AU
0
U.S. Expansion
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
30
6. International impact
Correlation of Returns with World
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
U.S. Contraction
Data through
Sept 2001
W
O
US
UK
CH
SE
ES
SG
NO
NZ
NL
JP
IT
EI
HK
DE
FR
FI
DK
CA
BE
AT
AU
0
U.S. Expansion
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
31
6. International impact
Covariance of Returns with World
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
U.S. Contraction
Data through
Sept 2001
W
O
US
UK
CH
SE
ES
SG
NO
NZ
NL
JP
IT
EI
HK
DE
FR
FI
DK
CA
BE
AT
AU
0
U.S. Expansion
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
32
7. Conclusions
• September 11, 2001
1. $400 billion in income over the next year
wiped out
2. We have not yet seen the full implications for
equity valuation
3. World markets very sensitive to what happens
in the U.S.
Copyright 2001. Campbell R. Harvey.
All Worldwide Rights Reserved.
33