Does increased leverage mean higher stock prices?

One of the weirdest puzzles of the Great Moderation is that equity-market volatility has been going down, even as leverage has been going up. Ceteris paribus, of course, if you increase the amount of leverage in a company or a set of companies, then the volatility of their equity will go up accordingly. On the other hand, if it's precisely the decrease in volatilities which is resonsible for the increase in leverage, then at least one would expect equity-market volatility to stay the same: the Great Moderation cancelling out the increased risk, as it were. But in fact equity volatilities have gone down, which if anything would seem to imply that there hasn't been enough increase in leverage.

Tony Jackson has an interesting take on equities in the FT today:

The conventional view is that they are, if not exactly cheap, at least not as wildly expensive as other things. They are certainly at the low end of their rating relative to bonds. And whereas some instruments such as junk loans and credit derivatives are arguably in glut, the supply of equities in the US and UK has been shrinking.
In short, equities have been overlooked and unpopular - until lately, anyway, a qualification I shall get back to. So it is to be hoped they are less likely to disappoint when things turn ugly.

This would help explain the puzzle, I think. Equities should have been more volatile than they have been, largely because they should have risen more than they have done in response to increased leverage. In fact, however, equities have not responded as one might have thought to the increased gearing that the corporate world has gone in for – which means that they might not have as far to fall in the event of a downturn.

Jackson also warns that this state of affairs might not last much longer:

Until quite recently, as I said, equities were relatively unpopular. But now, I worry that they, too, are being infected by the general mispricing of risk.
This came to mind with last week's news that a trio of big private equity firms are running a rule over J Sainsbury, the UK grocer. With a market capitalisation of £8.7bn ($17.1bn), (...) Sainsbury is trading on about 50 times historic earnings and more than 30 times prospective.

I'm also reminded of Joe Nocera's interview with Carl Icahn on Saturday, which came in the wake of Icahn announcing that he'd taken a position in Motorola:

Motorola has a very conservative balance sheet — and that’s what drives Mr. Icahn crazy. He hates conservative balance sheets. Mr. Icahn is almost surely right that if Motorola took on more debt and used more of its cash to buy back its stock, it would increase the stock price. The question, of course, is whether that’s the right thing to do.
The analysts I spoke to tended to think not. For one, the company has committed over $4 billion to paying for a recent acquisition. For another, they said, Motorola is in a very cyclical business — so a cash cushion is probably not such a bad thing.

These are stock analysts, no? On the face of it, it's weird that a stock analyst can say in the same breath that a certain course of action would both increase the stock price and be a bad thing to do. If it's really a bad thing to do, then the stock price wouldn't increase – any gains to shareholders due to increased leverage would be offset by a greater discount due to increased risk.

My conclusion is that increased leverage doesn't increase public share prices nearly as much as theoreticians might think – which is why a lot of the companies piling on the debt these days are private and not public.

Posted by Felix at 13:25 EST