The Business Cycle

Analysis of credit spreads by industrial sectors reveals that spreads differ among sectors and over time. Differences in credit spreads are primarily due to differences in industry products and services and the financial leverage of the firms in the industry. Spreads for issuers in the consumer cyclical sector increase significantly during economic downturns compared to spreads for issuers in the consumer non cyclical sector.

The discount rate used to value equity securities includes an additional risk premium, the equity risk premium. This risk premium is in addition to the risk premium on credit risky bonds because equity is more risky than debt.

discount rate for equity = R + π + θ + γ + κ

where: κ = additional risk premium relative to risky debt for an investment in equities Therefore the equity risk premium is: λ = equity risk premium = γ + κ Assets that provide a higher payoff during economic downturns are more highly valued because of the consumption hedging property of the asset. This property reduces the risk premium on an asset. Equity prices are generally cyclical, with higher values during economic expansions when the marginal utility of consumption is lower.

Equity investments, therefore, are not the most effective hedge against bad consumption outcomes. Because of this poor consumption hedging ability, equity risk premium is positive.

Corporate earnings may be related to the business cycle. Cyclical industries (e.g., durable goods manufacturers and consumer discretionary) tend to be relatively more sensitive to the phase of the business cycle. Companies in these industries have revenues and earnings that rise and fall with the rate of economic growth.

Defensive or non cyclical industries (e.g., consumer non discretionary) tend to be relatively immune to fluctuations in economic activity; their earnings tend to be relatively stable throughout the business cycle.

Price multiples such as P/E and P/B are often used in determining the relative values of companies, of sectors, or of the overall market from a historical perspective. However, it is inappropriate to judge the multiple in a historical context only. If the P/E ratio for S&P 500 is above historical standards, it could be that the index is overvalued, but it also could be that the index level is justified by current conditions.

Price multiples are positively correlated with expected earnings growth rates and negatively correlated to required returns. Therefore, price multiples rise with increases in expected future earnings growth and with a decrease in any of the components of the required rate of return (the real rate, expected inflation, the risk premium for inflation uncertainty, or the equity risk premium). As a result, the equity risk premium declines during economic expansions and rises during recessions.

Shiller’s CAPE (real cyclically adjusted P/E) ratio reduces the volatility of unadjusted P/E ratios by using real (i.e., inflation adjusted) prices in the numerator and a 10 year moving average of real earnings in the denominator.

Commercial real estate investments have:

• Bond like characteristics. The steady rental income stream is similar to cash flows from a portfolio of bonds. Furthermore, just as the credit quality of issuers affects the value of a bond portfolio, the credit quality of tenants affects the value of commercial real estate.
• Equity like characteristics. The value of commercial real estate is influenced by many factors, including the state of the economy, the demand for rental properties, and property location. Uncertainty about the value of the property at the end of the lease term gives commercial properties an equity like character.
• Illiquidity. Real estate as an asset class is characterized by illiquidity; it could take years to exit a real estate investment at its fair value.

Valuation

When estimating the value of real estate investment, the discount rate includes an additional risk premium for the lack of liquidity:

discount rate for commercial real estate = R + π + θ + γ + κ + φ

where: κ = risk premium for uncertainty about terminal value of property (similar to the equity risk premium) φ = risk premium for illiquidity While rental income from commercial properties seems to be more or less steady across business cycles, commercial property values tend to be very cyclical. Because of this, the correlation of commercial property values with those of other asset classes (e.g., equities) tends to be positive. Similar to equities, real estate provides a poor hedge against bad consumption outcomes.

Therefore, the risk premium required by investors for investment in commercial properties will be relatively high and often close to the risk premium required for equity investments.