Rally Ho, but First Understand Why It's Happening

Article excerpt

SINCE the low point in March, the All Ordinaries Index has rallied by 53%.

Some are surprised by this rally but there are good reasons for it. Many commentators claim that the market's earlier falls were the result of an overemphasis on debt finance. That is a simplification - the debt issue has two components.

First, debt is generally cheaper than equity. Companies get a tax deduction for interest and there is a much lower risk premium expected by banks - because they have first call on the assets being lent against.

The relatively low cost of debt can lead to over- emphasis on its use, as companies attempt to reduce financing costs. Such problems are exacerbated when too much emphasis is placed on performance measures like "return on equity"- which are enhanced by use of additional debt.

Second, lenders generally put in place covenants that help protect their interests. Accounting changes put in place over the past few years meant that assets had to be valued based on market valuation.

But market valuation is not only related to the prices of traded assets. Technical valuations, using the capital asset pricing model, are classed as market valuations, too, and these are very sensitive to market volatility - the higher the volatility, the lower the valuation. …