The average investor often overlooks the simple concept of how the market discounts risk. Risk and reward typically correlate strongly with one another. Currently, the risk premium that an investor demands in exchange for lending to broader markets is expanding. In broad terms, investors must be anticipating that future risk levels are increasing.
To better define the risk/reward relationship, we first point to the current situation surrounding the 10-Year Treasury Note. From July through the week ending August 12, 2011, the note's yield has declined 26 percent from 3.18 percent to a 2.34 percent. Today, the 10-Year dropped below 2 percent.
Previously, the lowest the yield on the 10-year was 2.12 percent, set in December 2008; when fears regarding the global credit freeze were near their highest levels. Yields for fixed income instruments respond inversely to price. Investors buy the 10-Year to reallocate their holdings away from risk and into this safe-haven, which has the effect of driving the price up. We note the key concept in finance: the yield on a 10-Year is often looked upon as the proxy for the risk-free rate of return.
Another component in the valuation of assets is the risk premium. As the risk-free rate of return shrinks the average risk premium an investor demands must rise. In other words, if the 10-year yield is falling, then market risk is actually on the rise. Let's assume for a moment that an investor wants a 10 percent return on their investment. If the risk free rate has dropped from 3 percent to 2 percent, then the risk premium that investor is willing to take on has grown by a corresponding amount. Otherwise, the investor's required return falls to 9 percent (signifying their aversion to taking on additional risk). Therefore, when we see dramatic drops in the 10-year, like what just took place, all else equal, investment risks must be perceived to be on the rise. Such a move is justified to mathematically keep the overall return at equilibrium.
Using the earnings estimates we can prove that these financial concepts are factoring into current market valuations. For our example we are using the earning's yield of the the S&P 500 Index. We took the recent annual earnings for the S&P 500, $112.8, and divided it by the index value for the week ending August 12, 2011 (1178.81). What we found was that the earnings-to-price (E/P) yield was 9.5 percent. If you subtract the corresponding 10-year treasury yield (i.e. the risk-free rate) of 2.3 percent from the E/P, the remainder is the risk premium for the S&P 500 Index (i.e. 7.2 percent).
The risk premium for the S&P 500 is relevant for two issues. First, the S&P 500 includes only well-capitalized U.S. operated firms of a significant size. If the market expects a total earnings yield of 9.5 percent for blue-chip U.S. firms, then obviously the required return (and associated risk) for lesser quality investments is going to be higher. Second, the current risk premium at 7.3 percent for the S&P 500 is well outside the norm (3.85 percent average since 2005 and 5 percent YTD).
This growing level of inherent risk in the broader markets and the market's appetite for risk does have an impact on oil prices that is worth considering. Although the Fed's posture towards interest rates (and their vow to hold them low into 2013) would suggest that the dollar will remain weak, this is no time to get bullish on oil. Look no further than price variability to understand our reasoning. Since 2005, one standard deviation in the price of a barrel of oil represents 25 percent of the total price. Conversely, one standard deviation in the S&P 500 Index approximates 15 percent of the total. Therefore, at a time when the market is risk averse, an investment in crude oil bears with it 66 percent more risk than the total market.
Suppose that inherent in recent market sentiment is a fear that the U.S. economic growth profile for next year will slip by about 10 percent or approximately three-tenths of one percent of GDP. Ultimately, such a scenario would be accompanied by less demand for oil. We used regression analysis to compute the value of one barrel of oil based on a 10 percent decline in S&P 500 earnings using observations starting in 2005. Our calculations peg the implied value of WTI crude oil at $84/barrel based on if NTM earnings estimates drop $11 for the S&P 500 Index. Our calculations would be well below what the EIA and leading economist recently had considered a reasonable assumption for next year (+$100/bbl).
Also, consider how much the current risk premium exceeds its average 52-week value. Recent history suggests that a growing risk premium (that is well outside this 52-wk norm) spells trouble for oil prices. Back in 2008, risk premium exceeded its own norm by 2 percentage points. Oil prices in the subsequent 10 weeks fell 53 percent. Again in 2010, the S&P 500 risk premium broke 2 percent above its norm and oil prices fell 5 percent in the following ten weeks. With the markets now showing a risk premium that is again 2 percent above the norm, a repeat of this pattern does not seem far-fetched.
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