OPPORTUNITIES
Stambovsky, Jeff
It's the Denominator, Stupid BY JEFF STAMBOVSKY While TV's financial talking heads are sure the NASDAQ fell out of bed almost entirely because of declining earnings and growth rates, the Fed...
...Wall Street analysts spend most of their time trying to get a handle on the earnings and cash generating prospects of companies...
...If investors didn't take Greenspan seriously when he admitted that he was paying attention to those things, they surely sat up and took notice last year when he becomes a new source of uncertainty and risk...
...The value of any asset—whether it's a factory, an apartment building, or a share in a public company—is equal to the present value of the cash flows that the asset will generate over its life...
...So what caused the spike in the denominator...
...How about a Fed Chairman who's been rewriting his job description on the fly...
...If the denominator changes quickly and violently it can dwarf the effect on stock prices of changes in the numerator...
...1.05 is the discount factor that you apply to that future dollar to get today's present value, which turns out to be a shade more than 95 cents...
...The good news is that the scare can only work once...
...What's AG talking about...
...The decline in the equity risk premium that gave us NASDAQ 5000 was probably brought about in large part by technology-induced productivity increases and higher economic visibility...
...It's the Denominator, Stupid BY JEFF STAMBOVSKY While TV's financial talking heads are sure the NASDAQ fell out of bed almost entirely because of declining earnings and growth rates, the Fed Chairman knows better...
...They're down...
...Greenspan's testimony, viewed in this light, sounds like the confession of the man who sent the horse on its way and then blamed the barn door...
...Why do we have to discount those future earnings...
...Simple: A dollar you get in a year is not worth as much as a dollar today even if it's guaranteed...
...So to calculate the worth today of any asset, you must first project the cash flows that the asset will throw off, and then convert those individual cash flows to their present values.You do this by dividing those individual cash flows (the numerator) by a discount factor (the denominator...
...OPPORTUNITIES In congressional testimony last month, Greenspan said that the problem is not earnings expectations, but "it's the discount factor, as best I can judge...
...They carry considerable risk...
...But what he hasn't explained is why the discount factor has shot up so quickly...
...What types of circumstances— exogenous events, to use the economist's term—could have brought about these seismic dislocations in the market...
...For stocks, to oversimplify a bit, the denominator is the risk-free rate plus an equity risk premium...
...Think landlords might get nervous...
...Imagine what would happen to the New York City real estate market if the Rent Control Board announced that it would deliberately set rent rates with the goal of decreasing the market value of apartment buildings...
...in other words, they obsess on the numerator...
...But stocks are not treasury bills...
...The reason...
...V 60 THE AMERICAN SPECTATOR ¦ April 2001...
...The quickest way to fix things was to throw a fastball at the market's head...
...A central bank that expands its own mandate in such a way itself Greenspan's testimony sounds like the confession of the man who sent the horse on its way then blamed the barn door...
...or the world—something broader than worries about earnings for a specific company—then the denominator gets bigger and stock prices can fall generally...
...There's nothing wrong with keeping an eagle eye on earnings and cash flow, of course, but the numerator can never be the whole story...
...It's that sharp increase in the discount factor which has brought the present value of assets down...
...namely, a very high degree of uncertainty and risk...
...Similarly, a Fed that is publicly understood to be interested in directly affecting the prices of equities will ipso facto cause a spike in the equity risk premium...
...If the risk premium gets bigger because investors are nervous about some event in the market appeared explicitly to target "high" equity prices, and then went out to shoot them down...
...If you wanted to take no risk, you'd buy a one-year treasury bill...
...To value their expected cash flows, you need a higher discount rate...
...If Greenspan's right, that "the problem is not the long-term earnings expectations" but rather the "discount factor," then the worst may be over...
...But real damage has been done...
...Remember "irrational exuberance...
...So let's explore the denominator a little further...
...If you had the dollar today, you could invest it...
...As Fed Governor Meyer said last year, "structural changes in the economy" may have raised the sustainable level of earnings and lowered their volatility thus reducing "the perceived risk in equities...
...It's just that the Fed decided that investors went too far...
...So it's not earnings, it's some "discount factor...
...That would leave you— assuming a one-year interest rate of 5 percent—with $1.05 in a year...
...It's not because of rising long-term interest rates...
...Alan Greenspan is suggesting that this is one of those times...
Vol. 34 • April 2001 • No. 3
