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Old 08-26-2007, 05:51 PM
Preem Preem is offline
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Default Yield curves

I'm reading a book, "The Only Three Questions That Count" by Ken Fisher.

In it, he makes an interesting observation about yield curves and their effect on the relative performance of value and growth stocks.

He says that when the yield curve is steep, i.e., long-term rates are much higher than short-term rates, this favors value stocks.

But, when the yield curve is flat, i.e., long-term and short-term rates are about the same, this favors growth stocks.

His reasoning is as follows.

Value-stock companies (low P/E) tend to raise capital through bank loans because it is cheaper for them than selling stock. They could get a bank loan for say 7-8% whereas if theiry P/E is 5, then selling stock would cost them 20% (invert the P/E of 5 to get 20%). When the yield curve is steep, banks want to lend money because the spread between long and short-term rates is high, making it very profitable for them to make long-term loans. This makes it easy for value companies to raise capital.

On the other hand, a growth company (high P/E) prefers to raise capital by selling stock. Suppose a growth company has a P/E of 50. They can raise money for 2% (1/50) by selling stock vs. 7-8% bank loan. When the yield curve is flat, banks are reluctant to make loans because the spread is small. So, the market favors companies who can raise capital in some other way such as selling stock.

Thoughts?
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Old 08-26-2007, 11:18 PM
CrushinFelt CrushinFelt is offline
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Default Re: Yield curves

Seems reasonable. Maybe it's too simplistic though? There are likely a lot of other factors that go into whether a company uses debt or equity to raise capital (capital structure for one).
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Old 08-27-2007, 11:20 AM
jively jively is offline
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Default Re: Yield curves

This sounds like something that is easy to backtest. Does this author show that growth stocks outperformed value stocks in 6 of the last 7 periods of flat yield curve, or whatever?

If they make the statement without research behind it, that's pretty lazy.

-Tom
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Old 08-29-2007, 04:05 AM
Preem Preem is offline
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Default Re: Yield curves

[ QUOTE ]
This sounds like something that is easy to backtest. Does this author show that growth stocks outperformed value stocks in 6 of the last 7 periods of flat yield curve, or whatever?

[/ QUOTE ]
It's not as easy to back test as it sounds because the author is talking about global yield curves, not just U.S. curves.

His assertion is that, prior to the globalization of financial markets, it was fine to only consider the U.S. However, now, you can't just look at the U.S. Even medium-size companies can easily borrow from banks in other countries if the rates are more favorable than here in the U.S.

The problem is that global yield data isn't as readily available as domestic data.

It's a very interesting book. I haven't yet decided whether it's useful, but Fisher has a good track record of beating the indexes for his clients.
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