November Review and Analysis
November Summary
While the past week’s rally was certainly gratifying, recent large price swings represent investors’ admission they are uncomfortable in their ability to assess the current level of credit risk. Access to capital at a reasonable price is vital to our economic well-being and weighted accordingly in our valuation models. Even for firms having strong credits, their suppliers or customers may be at the mercy of lending institutions.
I remain slightly concerned the coming bank stress testing, in spite of today’s actions by the Fed, ECB and other central banks, could further constrain the supply of capital, placing the industrialized economies in greater jeopardy than need be. We are already seeing banks restructure balance sheets to provide regulatory Tier 1 capital, and in the process, limiting lending to mid-scale businesses. If these concerns are not realized, fully expect to see equity markets undergo valuation multiple expansion as the cost of capital should fall from its current 9.1% down to the 8.6% range. This alone could fuel a 25% rally in valuations.
While raising permanent equity is appreciated by creditors, greatest efficiency occurs when capital is at an optimal point—excessive capital is not always the solution and can harm valuation multiples while increasing cost of equity as it lowers prospective return metrics.
Credit concerns began in August, almost coincident with the fall in stocks. In the chart appearing below, measured is the interest rate being charged by London banks, in US dollars, for loans to other banks having a 3 month maturity. While this and other real-time metrics, including credit default swaps, have become an important component in the setting of cost of capital, they do not rule the roost—longer-term free cash flow, return on capital, cost of capital and valuation do.
The balance of the report is available for clients of CT Capital LLC
