Cheap money means either higher stock prices or higher interest rates

Rich Karlgaard 05.21.07

Ken Fisher, fellow FORBES columnist and founder of a $39 billion fund, would never predict an 18,000 Dow. That's only because Fisher hates using the Dow as a reference. But he does say U.S. stocks are undervalued by about 40%.

"We live in a unique period of history," Fisher recently told attendees on the 11th FORBES Cruise for Investors. "All around the world earning yields--flip P/E to E/P to gets earnings yield--are higher than ten-year government bond yields. For the American S&P Index the E/P is 6.7%. Compare that to the cost of borrowing. The average S&P company can borrow money at 5.8% pretax, or about 3.8% aftertax."

Call it the Fisher Spread. It's nearly three points. Historically huge.

The Fisher Spread leads to Fisher's calculus: S&P Index companies borrow money at an aftertax average rate of 3.8% to buy back their shares, which, on average, are yielding 6.7%. It's no surprise that companies are buying back their shares. (Globally, the Fisher Spread between E/Ps and ten-year government bonds is even wider.)

Private equity firms play the same game. In fact, they play it better and more aggressively. That's their sole purpose. By smartly playing the Fisher Spread, private equity firms can't lose in these conditions:

If the stock market goes up--thus narrowing the Fisher Spread--the private equity firm can take its companies public. If the stock market goes down--thus expanding the spread-- the private equity firm can mark up its companies and sell them to other companies. "This game will continue until the earnings-yield/bond-yield gap closes," says Fisher. That is, when the Fisher Spread ceases to exist. When it ends, it will end badly. Companies will fail to grasp that the Fisher Spread, not CEO genius, makes acquisitions work. Private equity firms will become overextended and go bust. But for now--and likely for another 24 to 36 months--the case for buying stocks has never been stronger. link