Friday, May 7, 2010
Can fear kill growth? I doubt it. As this chart shows, the market's fears (as proxied by the Vix index) have surged in recent days, to levels not seen since early April '09, yet equity prices haven't fallen by much more than we would expect to see in a typical selloff/consolidation (about 10%). I think this shows that fear levels are much higher right now than obvious threats to the economy, and I think that makes sense.
As I've been pointing out for a long time, in my attempts to justify my belief that equity valuations have not been inflated, there has been no shortage of things for the market to worry about. Here's a short list: Will the Fed reverse its massive quantitative easing in time to avoid a surge in inflation? Will the coming wave of mortgage defaults trash the housing market again? Will soaring U.S. deficits lead to a major increase in tax burdens? Will the deficits of the PIIGS result in the downfall of the euro? Yesterday we saw the perfect storm: Greek riots, numerous pundits predicting the imminent demise of the euro, widespread concerns that Greece's woes will prove to be contagious and eventually cripple the Eurozone economy and short-circuit the U.S. recovery, and the coup de grâce, electronic trading run amuck. Unusual levels of fear and uncertainty have been with us for well over a year now—it's nothing new. All that happened in the past few months was that a new source of fear (a threatened Greek default and all the consequences that might bring with it) has appeared. The market has not yet become confident enough in a global recovery to avoid panicking at one new set of unknowns.
It's understandable that investors' confidence has been shaken to the core; there are just so many unprecedented things going on in the world right now. Buying and holding equities—or any risk asset at this point, since all have been hammered of late, as the next chart shows—requires true conviction, and the willingness to put up with some gut-wrenching volatility. But isn't that the case with the early stages of any bull market? Things are never clear until well after the fact.
My approach to situations of great uncertainty, such as we have today, is to focus on the underlying fundamentals, in the belief that a) the fundamentals usually win out in the end, and b) it never pays to underestimate the ability of the U.S. economy, in particular, to cope with adversity.
For some time now we have seen so many signs of recoveries (many of the V variety) that an economic relapse seems almost unthinkable at this point: commodity prices are very strong; credit spreads are much tighter; industrial production has turned up; the ISM indices are on a tear; Asian economies are booming; world trade is expanding; the U.S. economy is in job-creation mode; corporate profits are very strong; and productivity gains in the past year have reached record-setting highs, to name just a few. None of these signs of recovery have deteriorated by any significant amount, and most just continue to improve; moreover, recoveries are self-sustaining once they get started, thanks to the inherent entrepreneurial abilities of our economy and man's insatiable desire to raise his standard of living.
So many positives, yet none of the negatives, like very tight monetary policy, that typically lead to a recession. To be sure, there is the real threat that U.S. tax burdens might rise significantly starting next year, but we have an important election in November that could shift the balance of power from those pushing for higher taxes to those pushing for reductions in spending. It's too soon to give up hope on the fiscal policy front.
But what about our markets, that appear so vulnerable still to program trading, derivatives, etc.? I think there is a good argument to be made that trading-induced volatility, such as we suffered through yesterday, brings with it the seeds of its own correction. On average nobody benefits from extreme price moves, and most people lose, even the ones who got the whole thing started. I'll wager that those running electronic trading programs will think twice and three times about letting them run unsupervised in the future. The market has evidently not regained the liquidity necessary to support a lot of trading. Until it does, the potential for expensive whipsaws is going to be a major force restraining participation in high volume trading.
In any event, high levels of implied volatility act as a natural shock absorber for nervous markets. That's because it becomes more profitable to sell options rather than buying them, and this serves to automatically dampen market moves. Selling options is akin to buying low and selling high (that's how delta hedging or dynamic option replication works), so high implied volatility provides a huge incentive for traders and speculators to adopt strategies that will effectively add liquidity to the market. In short, there are many ways in which the market, left to its own devices, can sort things out and become more efficient.
I remain convinced that we are in the early stages of a sustainable recovery. It's not a robust recovery, unfortunately, because government has grown like topsy, and regulatory and tax burdens are rising. "Stimulus" programs based largely on transfer payments and make-work projects only squander the economy's resources. But it is nonetheless a recovery, and 3-4% growth rates for the foreseeable future are entirely possible and quite likely. It still pays to be optimistic.
Posted by Scott Grannis at 2:47 PM