Edmund Simms's avatar
$30.6m follower assets
Cost of capital
Finance’s most important yet misunderstood price is capital. Here’s what happened to the cost of money in the past fortnight.

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Stock prices rose last fortnight. The S&P 500, an index of big American companies, climbed 4% to 3,991. The market has bounced back from its October lows but is still down 13% in the past year. I value the S&P 500 at 4,154, which suggests it is 6% undervalued.


The companies in the index earned $1.8trn after tax in the past year. They paid out $499bn in dividends and $981bn in buybacks, and issued $69bn worth of equity.

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Government bond prices rose. Yields, which move the opposite way to prices, fell as inflation expectations did. The yield on a ten-year US Treasury bond, a critical variable analysts use to value financial assets, dropped 16 basis points (bp) to 3.5%. Investors expect inflation to average 2.1% over the next decade, down 10bp from the rate they expected last fortnight.

Hence, the real interest rate, the difference between yields and expected inflation, declined 6bp to 1.4%. These inflation-adjusted rates are up two percentage points in the past year.

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Corporate bond prices also went up. Credit spreads, the extra return creditors demand to lend to businesses instead of the government, fell by 13bp to 1.6%. The spread on these BBB-rated bonds is up 39bp in the past year.
The cost of debt, the annual return lenders expect when lending to these companies, collapsed by 29bp to 5.1%. Refinancing costs have almost doubled, up 2.1 percentage points, in the past year. Lenders now charge firms about the highest interest rates since 2009.

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The equity risk premium (ERP), the extra return investors demand to buy stocks instead of risk-free bonds, rose 21bp to 5.4%. It’s now 57bp higher than where it was a year ago. In addition, the cost of equity, the total annual return these investors expect, rose 5bp to 9%, 2.2 percentage points higher than last year. These expected returns are also roughly in line with the long-term average.

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Todor Kostov's avatar
@valuabl Great info!

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