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Old 08-26-2007, 05:51 PM
Preem Preem is offline
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Join Date: Jul 2006
Posts: 98
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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