Monday, August 31, 2009

Thoughts on the market's huge rally

The S&P 500 is up 50% from its low on March 9th of this year. I detect a wave of sentiment that says it's time for a correction, that prices may have gone too far, too fast, that the news isn't good enough to support such high prices. But as I said in an earlier post, the market is not exactly priced to good news or even to a recovery. I showed a chart of credit spreads to illustrate my point: credit spreads are still higher than they were at the peak of the 2002 financial crisis, which at the time was the worst period for corporate bonds since the Depression. If the market is still priced to a rather grim future, I question whether or why a significant correction is in order.

The first chart makes the same case but from a different perspective. It shows Bloomberg's Financial Conditions Index, which is "the number of standard deviations that current financial conditions lie above or below the average of the 1992-June 2008 period." Financial conditions are still about one standard deviation below the levels that might correspond to "average." They are today about the same as they were during the 2001 recession and the 2002 corporate bond market collapse. In other words, current financial conditions are still far from below what might be called "healthy."

The second chart shows the history of 10-year Treasury yields. Currently at 3.42%, 10-year Treasuries are still at very low levels from an historical perspective. They've only been lower during periods of deflation and/or depression. Given the Fed's incredibly expansive policy actions, buying Treasury bonds at today's yield levels only makes sense if you think the economy is incapable of mounting a meaningful recovery, while the risk of another (or an extended) recession remains high. (I don't share this view of course.) In short, this rally has not been driven by optimism, but rather by a reduction of pessimism. The market was priced to Armageddon in March, and now it's priced to a recession.

My thesis since November of last year has been basically unchanged: I have thought that the market was overly pessimistic about the economy's future, and valuations were therefore very attractive. I have seen numerous signs, beginning last October, that leading financial market indicators, such as swap spreads, were pointing to improvement, yet the market was priced to continuing disaster. The encouraging signs I began to identify in October and November turned into "green shoots" that are now appearing almost everywhere: declining credit spreads, declining implied volatility, rising commodity prices, rising shipping rates, rising confidence, rising home sales, a bottoming in residential construction, improving manufacturing conditions, rising capital spending, declining unemployment claims, etc.

Like the market, I was blindsided by the dreadful selloff that occurred from mid-February to through early March. I think that selling climax was the market's way of expressing its horror at the degree to which fiscal policies had suddenly shifted to the left: a massive increase in so-called "stimulus spending" threatened a similarly massive increase in future tax burdens, not to mention a gargantuan increase in the public debt.

Since then, my thesis has reasserted itself. From the vantage of politics, the rally has been driven by a lessening of the horror of big government, and that in turn has been largely a function of Obama's policy prescriptions being rejected by the electorate and bogged down in Congress. Things are not turning out as badly as the market once thought. That's not to say that the future looks bright, simply that the future looks less ugly.

So my thesis is still this: the outlook for the economy that is implied by current market pricing (e.g., the level of Treasury yields, implied volatility, credit spreads and P/E ratios) appears to me to be worse than what the economy seems likely to deliver. I think we're in a recovery, but the recovery is going to be sub-par; we are likely to see growth of 3-4% per year for the next several years, but this will not be enough to get the economy back on the track that it was on for the past few decades. It's going to feel like a jobless recovery, a tepid recovery, and a frustrating recovery, but it will still be a recovery. The market expects a lot less than that, however, so it still pays to be optimistic.

1 comment:

robert said...

Scott, I agree with you but the one thought that keeps me up at night is the potential problem with the CMBS market and the lack of commercial real estate financing. Yesterday's article in the WSJ is a good recap.
How do you see the recovery overcoming this one?