Credit Trends

We’ve been saying for years investors DO NOT understand risk. The numerator (cash flow) has not shifted much over the past quarter-it’s the denominator, cost of capital, as only can be measured by our comprehensive credit model, factoring everything from tax rate and revenue stability, free and operating cash flows, yield spreads, and 50 other metrics, all carefully defined.

The problem is, in a nutshell, investors are setting risk thru the Capital Asset Pricing Model, which is terribly flawed. They look towards EDITDA, which is terribly flawed.

COMING THIS FALL: Cash Flow, Cost of Capital, and Security Valuation, McGraw-Hill

Central Tenet: The risk premium should not be set by stock volatility, as implied by the capital asset pricing model, but by the cash flows and credit worthiness of the entity.

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Switching stations, I heard the first minute of his show this evening, saying “ investors are looking for a reason to sell.”

Someone please tell Mr. Cramer, large investors look to make money, and will sell if they have information not reflected in the current price of the security. If someone sells, someone who holds the opposite opinion buys.

But what he doesn’t really understand, and something I have been pointing out the past three months, is that current financial risk is greater than stocks are pricing in. When we called the market bottom in March, we did so as free cash flow increased, discretionary expenses were being reigned in, and valuations were low.

Over the past quarter, we are finding cash flows, adjusted for discretionary spending growing very modestly, credit health, as measured by our credit model (which incorporates everything from revenue and tax rate stability to yield spreads and off balance sheet debt, and everything in between), showing just minor improvement over the prior quarter. Yet, stocks were rising such that the free cash flow yield was approaching 4%.

And that is why stocks have, in general, declined. Not because “investors are looking for a reason to sell.”

We stated three months ago that although stocks almost never sell precisely at fair value, they were about 10% overvalued. Today, they are about 4% overvalued, based on a 3.6% 10-year Treasury bond, and a 8.4% cost of equity capital.

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