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Two charts came across my desk in the last 24 hours that are so misguided, it is insulting to see them published in major financial media.

So I want to address them.


Crime #1:  Value versus Growth
First up, this value-growth ratio chart, coming to us from Bloomberg.



The chart would seem to imply value is massively oversold versus growth.  So what's wrong here?

Total return indices are not a valid valuation comparison.  Historical performance has little to do with current relative valuations.  

Why would we even expect price ratios to mean revert?  Consider: what if growth stocks just simply had better earnings growth over the last 20 years.  Wouldn't we expect their prices to appreciate more quickly?

This is all especially for an index with moderate turnover.  The basket of stocks in the MSCI World Value and World Growth indices in 1999 are not necessarily the same as those today, making index level comparisons rather moot.

If we want to make an argument about mean reversion, we'd do better to look at spreads in fundamental variables (e.g. P/E ratios): but even then, timing is notoriously difficult.  


Crime #2:  Greek vs US Treasury Rates
I'm seeing this one all over, but we'll use this chart from the Financial Times.

 

"It's absurd!" they crowd exclaims!  "Greece borrowing at the same rate as the U.S. government?"

Not so fast.

As tempting as it can be to compare yields-to-yields, we need to consider the fact that these bonds are priced in different currencies.  

So first, let's position ourselves as European investors.  The "safe" reference rate in the Eurozone is the German Bund.  The 10-year bund is yielding -0.378%.  Compared to that rate, Greek debt offers a 250 basis point spread.

Is that high?  Is it low?  As a reference point, consider that the ICE BofAML European High Yield Master OAS Spread is currently 368bp.  So the market may not think Greece is complete junk, but there is certainly a  premium to be paid in borrowing.

The important point here is that quoting the level of Greek rates is meaningless without understanding the spread.

Now let's connect this back to U.S. Treasury rates.  How can I compare by US Treasury yield versus a Greek bond yield?  We have to tack on a currency forward.

So here's the real horse race:

  1. Buy $100 in 10-year US Treasuries @ 2.05%
  2. Convert $100 to EUR, buy 10-year Greek bonds @ 1.99%, lock in 10-year EURUSD forward rate.
Assuming no reinvestment of coupons, option #1 gives us $120.5 after 10 years.

What does #2 look like?  First, we convert our $100 to 89.73 EUR at the current spot rate.  We then invest in the 10-year Greek bond, which will leave us with approximately 107.58 EUR in 10 years (again, assuming no reinvestment of dividends).

But now we've got an issue of comparing future USD vs future EUR.  The simple answer to this problem is to just lock in our conversion rate today using a forward.

Currently, the mid-price for the 10-year EURUSD forward is 2,785 pips.  These forwards are quoted as Forward Points = Forward Price - Spot Price, so this forward gives us the right in 10 years to convert at 1.3855 EURUSD.

Given this locked-in rate, after 10 years we convert our 107.58 EUR back to USD, leaving us with ... drum roll, please ... $149.05.

Turns out we earn quite a bit more return for taking on that Greek default risk than it first appears.

As a departing thought, consider this: when something seems absurd, try to construct the trade that exploits it.  Often we'll find that the market is not very willing to provide us with the free lunch we thought.


⚡️Corey
 

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