October 27, 2007

The Credit Crisis and the Fundamentals of the Stock Market

Ambose Evans-Pritchard writes in a blog entry at the Telegraph:
Even so, equities have not begun to reflect the reality that the 2006-2007 credit bubble has popped and cannot be easily reflated at a time of stubborn, lingering inflation. Spare me the mantra that the “fundamentals” are sound. Credit is the ultimate fundamental.
This is a folly. It is natural for the stock prices to edge higher when the alternative investment opportunity that is provided by the credit market is in trouble. Upward drift in the stock market is not always a reflection of belief in higher profits. In this case it is more likely to be a lack of good alternatives.

It is a mistake to report the stock market mood as "jubilant" after the Fed acknowledged the credit market troubles with the rate drop. The mood is quite probably more like: "These stocks are going to stink at these prices, but hey, look at the alternatives." Willingness to buy at a higher price without any underlying positive indicators is a sign of acceptance of lower yields. I would hesitate to call such a mood "jubilant".

The recent returns to lower stock market price levels have most probably been caused by disappointing profit reports, especially from the financial companies.

There is some correlation between the credit market and the stock market, but these markets are also ever competing against each other. A crisis in the credit market is bound to have a short term boost in the stock market. If an investor is faced with modest yields and a high risk in the credit market, he might just as well put his money into the stock market.

On the other hand, trouble in the credit market might actually be a real boost to established companies with sound cash positions. After all, tightening credit conditions cause hard times for their growth-hungry and deeply indebted smaller competitors. To the economy in general, this is not good news.

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