Monday, Feb. 23, 2009
SIDEBAR: K-STATE INVESTMENT EXPERT SAYS INVESTORS WHO WANT TO GET BACK INTO THE STOCK MARKET SHOULD WATCH THREE KEY FINANCIAL BENCHMARKS
MANHATTAN -- Three key financial benchmarks may prove helpful to investors who have pulled out of the roller-coaster stock market but are seeking signs of when it could be time to return, according to a Kansas State University investment expert.
Eric Higgins, associate professor, Gates Capital Management Faculty Fellow and head of K-State's department of finance, said the markets are nervous right now and this is creating a situation where stock valuations are no longer based on fundamentals but on fear.
"That is why you see so much volatility and so many good companies trading at relatively low prices," he said. "When will this irrationality change? To determine when markets are returning to fundamentals, it is important to look at benchmarks that measure the level of fear in the market."
These benchmarks are the VIX, the TED spread and the default spread, he said.
The VIX is a stock market volatility index that trades on the Chicago Board Options Exchange.
"The VIX provides a basic measure of investors' expectations regarding expected volatility in the market," Higgins said. "It also gives a gauge of the level of 'fear' in the market. The higher the VIX index, the more 'fear' in the market."
Higgins said the VIX index typically trades around a value of 20-25. During the height of the market crisis, the VIX traded as high as 80; right now, it is trading around 45.
"This is still high relative to historic values of the VIX," Higgins said. "As this continues to fall, we should begin to see markets returning to fundamental values."
The second benchmark is the TED spread, which refers to the difference between U.S. Treasury interest rates and the LIBOR, the London Interbank Offered Rate. The LIBOR rate, Higgins said, is the interest rate at which large banks lend to each other.
"Typically, the TED spread is less than one-half percent," he said. "In a normal market, there is usually very little difference between the risk of a large bank and the U.S. Treasury. Thus, the low spread between the Treasury rate and LIBOR. At the peak of the economic crisis, however, the TED spread went as high as 4.5 percent. This means that banks were not lending to each other and this helped fuel the 'liquidity crisis' that we observed in the credit markets."
The TED spread is currently close to 1 percent. "This is a good sign for markets as it indicates the money is beginning to flow in the credit markets," Higgins said.
The third benchmark is the default spread, the difference between long-term AAA bond yield and long-term treasury yields.
"The higher this difference, the more perception of risk in the corporate sector," Higgins said. "Federal Reserve officials look at this measure when trying to define what they call a 'flight to quality.' As the default spread increases, this indicates that more and more investors are moving money into government bonds."
When this happens, Higgins said, investors have basically lost their trust in corporations or in the ability of ratings agencies to assess risk.
"During the peak of the economic crisis, the default spread peaked at more than 2.5 percent -- higher than the default spread observed immediately after Sept. 11," Higgins said. "This also is interesting because over the recent period the Federal Reserve has cut interest rates to near zero. However, AAA bond rates were going up. This again shows the fear that was in the marketplace at the peak of the economic crisis. Currently, the default spread has fallen and people are once again returning to AAA-rated bonds."