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The effects of the Great Recession of 2008 were experienced all across debt and equity markets as businesses earnings fell and investors became cautious and demanded higher expected returns because they regarded stocks to be riskier relative to cash. It is indicated that the value of the Wilshire Index fell significantly during the recession, and the CBOE Volatility Index value increased (Graph 1). This situation leads to a higher risk premium, which refers to the return of stocks over risk-free rates, as risk-averse investors need to be compensated for investing in stocks rather than cash. It also implies that stock prices are low when the market risk premium is high. Although cash deposit rates declined during the recession as well, their demand increased during the recession as investors sought safe assets to place their funds rather than investing in highly volatile equity markets (Parrino, Kidwell and Bates 21).
Furthermore, the default risk on debt instruments increased, and investors demand for treasury bonds, which are considered more secure, also raised. It is noted that 1-month, 6-month, 5-Year, and 10-Year treasury rates significantly declined during and after the recession period as their demand increased (Graph 2). Therefore, it is argued that the risk premium is anticyclical as it reduces during the period of economic boom and increases when the economy experiences negative or slow growth. This is also reflected in the changes recorded in the Aaa and Baa corporate bond yields (Graph 3). It is noted that bond yields were declining before the recession and then sharply increased during that period.
It is observed that the yield curve before the recession became inverted (Graph 1), which gave a signal of a nearing recession. During economic expansion, investors seek higher rates in the long term as they aim to be compensated for the opportunity cost of investing in bonds rather than other types of assets. However, the inverted yield curve before the financial crisis that investors had negative views about the economic state in the short term, and they considered a high risk associated with their debt investments in the near term. The yield curve inverts when short-term interest rates are higher than long-term rates as it is noted from Graph 1 that 1-month and 6-month Treasury constant maturity rates were more than 5-year and 10-year maturity rates during the pre-recession period, i.e., 2006-07 (St. Louis Fred). The risk-free interest rates fell during the recession, and it is noted that short-term rates were below long-term rates (Graph 2). It is stated that when a country experiences an inverted Treasury yield curve, it is most likely to face an economic recession in the short term. The US economy had one of the longest periods of economic expansion after the early 1990s. However, economists were of the view that this growth would slow down an overheated economy along with weaknesses in the governments policies would not suffice fiscal and monetary stability.
The dividend discount model is commonly utilized for valuing equity stocks, which uses historical dividend data of a firm to predict future dividends whose present value represents the intrinsic value of its shares (Cecchetti and Schoenholtz 198). It is stated that the cost of equity, which is the expected return by investors, increased during the recession and the dividend growth rate of firms decreased as they were unable to generate high earnings. This means that the discount factor for determining the present value of future dividends became small. Therefore, the intrinsic values of stocks declined substantially during the crisis period.
References
Cecchett, S., & Schoenholtz, K. (2017). Money, Banking and Financial Markets (ed. 5th). McGraw Hill.
Parrino, R., Kidwell, . S., & Bates, . (2017). Fundamentals of Corporate Finance. John Wiley & Sons.
St. Louis Fred. (2020). Interest Rates. Web.
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