Wednesday, January 11, 2012

Alcoa's Outlook Not Really a Cause for Optimism

Alcoa $AA gave results recently and the markets liked the outlook given by the company. Indeed any sign of an optimistic outlook from a bellwether like Alcoa will have equity investors excited. But what was really behind the underlying assumptions in Alcoa’s bullish outlook statement?  Moreover why are some investors taking this macro economic outlook from Alcoa and concluding that it’s now time to pile into equities?

The Equity Risk Premium

One argument relies on the valuation of the equity risk premium. In other words, equities look cheap compared to bonds right now. Whilst I’m sympathetic to this argument, I think it is flawed. I think the traditional academic treatment of bonds vs. equities is predicated on bonds having a risk weighting of 1 and then building in a premium for what you would then pay for the 'riskier' equity. 

All of which is fine, if you are happy to believe that the risk weighting of bonds really is 1. Clearly, some parts of the market thinks that Germany is more than 1, otherwise why buy debt on negative yields...

...whilst the reluctance to lend Italy money for 10 years goes on unabated...

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