Monday, September 13, 2010

Fear subsides, prices rise

My interpretation of the equity rally that has occurred this month is a bit different from David Rosenberg's, who believes that the market is no longer worried about a double-dip recession (even though he remains pretty confident that there will be a double-dip). I think the market is still very worried about a double-dip, only now a bit less so. The yield on 10-yr Treasuries is still extraordinarily low, and to me that is a sign that investors are still very worried about the economy's ability to grow.

I've showed this chart many times in the past, and it remains the case that there is a strong inverse correlation between the Vix (a proxy for the market's level of fear, uncertainty and doubt), and the level of equity prices. At just under 22 today, the Vix is still historically elevated; 12-15 would be a level consistent with a relatively healthy economy. Similarly, credit spreads are still quite elevated. Both are thus signs of a market that is still quite worried about the economy. On the margin, things are getting better, as the Vix slowly subsides and credit spreads slowly narrow. But the level of the Vix and credit spreads is still indicative of a good deal of concern among market participants.


Frozen in the North said...

For what its worth, my guess is that fear is subsiding because of exhaustion! It's been almost 3 years since the crisis has started. None of the news is good, its just a lot less bad (which to a certain degree is good). Chief economist of had an interesting comment, people are replacing cars out of necessity not out of choice. That speaks volume to an iconic american product such as automobile.

Frankly, you sound downright gloomy today, that is worrying

John said...

When the majority stop worrying, it will be time to worry.

Exaustion of fear is a sign of a bottom, not a top.

People are replacing cars out of necessity because the average age of the fleet exceeds 10 years. This is good since the procrastination option is being exausted.

The markets will turn higher long before the news headlines turn positive. There is no investment edge from reading headlines. They have long been discounted.

Just my cheap opinion, FWIW.

Benjamin said...

Well, I still have fear. We may be the next Japan.

Japan experimented with tight money and fiscal stimulus for 20 years. The results have been horrible, with zero inflation, and 75 percent plummets in equity and property markets. The yen is very strong. They have indebted themselves to the moon. Rising global commodity prices and gold have meant nothing--Japan is now in deflation

Basically, we are doing the same thing. Fed officials still pettifog about an inflation that is gone, maybe not to return in our lifetimes. As Scott G. pointed out recently, the Boskin Commission found the CPI overestimated inflation by about 0.5 percent, maybe more. I suspect more, as the private sector develops new goods and services so rapidly. We may be slipping into deflation as we speak.

The Inflation Hawks are fighting a ghost, and the worst bogeyman of all, the "monster that might return, in what form we do not know."

I would be a lot more optimistic if the USA would adopt much less fiscal stimulus, and a wide-open throttle and quantitative easing by the Fed.

newjava456 said...

Thanks for the Blog. I have to think the automated trading affects the VIX. As a programmer all I hear about nowadays is how somebody's buddy is making a killing working for a high-frequency trading house.

septizoniom said...

why should fear and price be inversely related? why do you think this means anything to anyone? how do you know it is causal?

Benjamin said...
This comment has been removed by the author.
Benjamin said...

Well, good news. More "serious" people are saying the Fed will in fact engage in much-needed quantitative easing. Maybe the dithering "Japan Wing" of the Fed is getting slapped down.

Yields Fall to Eisenhower Low in Pimco-BofA View of Fed Easing

By Liz Capo McCormick

Sept. 13 (Bloomberg) -- Bloomberg)
Bond investors are growing more convinced that Federal Reserve Chairman Ben. S. Bernanke will push Treasury yields down to the levels of the 1950s with another round of asset purchases.

Goldman Sachs Group Inc. and Pacific Investment Management Co. project the Fed will resume quantitative easing by purchasing U.S. government debt as soon as this year to prevent what they see as a 25 percent chance the economy will slip back into a recession. Bank of America Corp. says the central bank will send the 10-year note yield to a record low of 1.75 percent in the first quarter of 2011.

Derivatives show investors are betting on lower yields at a rate not seen since the Fed began buying Treasuries in March 2009, even after companies in the U.S. added more jobs than forecast and manufacturing expanded faster than estimated in August. Policy makers are attempting to push borrowing costs lower and investors into higher-yielding assets such as corporate debt to help sustain the expansion and spur hiring.

“The Fed will have to be proactive and do quantitative easing as growth slides,” said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York. “The Fed will be aggressive with their purchases because they don’t want to run the risk of it not working and them losing credibility.”

Buddy R Pacifico said...

Expanding some of Newjava456's comment about high frequency trading: I think there is a new lower end for the VIX which is higher now. The recent Flash Crash and recovery builds in a new elevated VIX level because of automated trading.

Scott Grannis said...

Re: automated trading and the Vix. I don't believe there is a causal relationship here. The Vix Index is a proxy for how expensive options are. When the Vix is high, options are expensive to buy. Buying options reduces an investors exposure to risk, since the worst that can happen is that they expire worthless, yet they retain almost all the upside that owning something has.

The Vix index is high because investors are still very risk-averse, and willing to pay abnormally high prices for options that limit their risk. If automated trading were to take advantage of this (in the belief that it is an anomaly), then automated trading would adopt an option-replicating strategy that would effectively sell when prices rise and buy when prices fall (this is known as replicating a short option exposure through delta hedging). This would have the effect of reducing the market's volatility, thus leading to a lower Vix.

John said...

Dividends are contributing to the decline in fear among market participants.

John Chambers, CEO of Cisco announced at an analysts conference today that the company will initiate a dividend next spring.

Jamie Dimon, CEO of JP Morgan Chase announced the company's intention of restoring a dividend of 30 to 40% of normalized earnings. Some think this can occur in the first quarter of 2011.

Microsoft has indicated it plans to adjust its dividend policy toward higher dividends.

Money is and has been coming off the sidelines into dividend paying stocks. As dividends rise, fear should continue to decline, and equity prices should rise. They will not rise in a straight line, but stock price declines should be met by buyers hungry for yield.

Daniel said...

What about the new proposed tax increases on dividends? sounds like they will go up, but capital gains tax will stay the same? if this is the case, wouldn't companies with no dividends like Apple be a more attractive investment since one stands to gain more from capital appreciation? (and lower taxes?)

John said...


That has been the debate for the last several years...what is the best way to return cash to owners? Dividends or share buybacks? The pendlum has been on the side of buybacks but I believe it is swinging back toward dividends. May companies, of course, do both.

IMO Apple will face increasing pressure to return capital to owners. Their free cashflow exceeds capital requirements and the cash building on the balance sheet earns little or nothing. At some point they will either need to invest it (aquisition?), buy in stock (not cheap) or pay it out in dividends.

It appears there will be a compromise sometime this fall on the tax issues. IMO it need to be addressed. Uncertainty is not helping the economy.

John said...


One other point on the cash held by US companies overseas: According to John Chambers, CEO of Cisco, there is 1.2 Trillion held overseas by US corporations that will probably NOT be brought back and invested in this country because of high taxes. Unless the tax rate is reduced, it will likely stay overseas and be invested there. Lower taxes will bring the money back here for job creating investment.

Daniel said...

Thanks, John. good points. Sounds like the whole world is impatiently waiting for the tax rules to be clarified.