Tuesday, May 1, 2007

. Jeremy Siegel. "Presenting the bullish case for equity valuations", Financial Times

Jeremy Siegel, professor of finance at the Wharton School, establishes the bullish case for equity valuations by arguing —among other things— that "the reduction in economic volatility should reduce the equity risk premium". Here's another the way to put it: lower macro volatility leads to an increase in the supply of loanable resources in the credit market, which (other things being equal) means lower long-term interest rates and higher equity valuations.

The recent Bank of England report on financial stability explains the process — "Less volatile collateral values promotes steady credit growth rates":

The stability of the economic environment may have encouraged the provision of more long-dated and subordinated finance because lenders are more confident that firms will not default as a result of sharp shocks. Loan payments are also being backloaded ... Even lowly rated firms are able to raise subordinated finance, with issuance of second-lien loans and mezzanine notes (which fall between equity and debt in a firm's capital structure) increasing over the past year.

Can we legitimately use the VIX as a proxy for macro volatility? It is an open question. Our own Endogenous Liquidity Index does just that — it fell as much as 4.8% yesterday as the VIX surged past 14.

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