Assessing the market's assumptions

In order to have a view on whether the market is attractive or not, it's essential to consider the assumptions that are reflected in market pricing. What follows is a review of a variety of key market-based indicators that provide insights into the assumptions the market is making about the future. Taken together, these indicators suggest that the market is still quite cautious and concerned about the future. Nowhere is there any indication that the market is priced to optimistic or rosy assumptions about economic growth, inflation, interest rates or corporate profits. Indeed, most indicators reflect a market that is already discounting a deterioration in corporate profits, sharply rising yields, and/or higher corporate tax rates. What this suggests is that if the future turns out to be less problematic than the market is expecting, then there is still a lot of upside potential in equity prices.

This chart compares the spread on 5-yr swaps (a measure of the credit risk of generic AA-rated banks) to the spread on 5-yr A1 Industrial corporations (a measure of the credit risk of generic industrial corporations). Swap spreads have been trading at "normal" levels for most of this year, but industrials are still trading at levels that are elevated in an historical context. This means that the market still worries (not a lot, but more than it would if the outlook were healthy) about the viability of large industrial corporations over the next several years. 

This chart compares spreads on high-yield bonds to spreads on investment grade corporate bonds. Credit spreads are a good measure of the perceived default risk of corporate debt, and are generally correlated to the health of the economy—spreads tend to rise around recessions, and fall during recoveries. As the dashed green lines show, the current level of spreads is substantially above the levels that have prevailed during economic expansions. This implies that the market is still quite skeptical of the economy's ability to thrive.

Credit default swaps tell a similar story to that of credit spreads in general: the market's perception of default risk is still substantially higher than it was prior to the onset of the 2008 recession.

In theory, the price of a stock is the discounted present value of its future after-tax profits, and thus a function of three variables: interest rates, tax rates, and profits. Therefore, there should tend to be an inverse correlation between the level of yields and the price of a stock; the higher the level of yields, the greater the discount on future cash flows, and vice versa. This chart shows how the value of stocks (the blue line, which is the ratio of the S&P 500 index to nominal GDP) compares to the level of 10-yr Treasury yields (the red line, which is shown with the y-axis inverted). When yields were low and relatively stable in the early 1960s, the economy was strong and stocks were well-priced. As yields rose in the 1970s, stock prices fell relative to GDP, and subsequently rebounded as yields declined in the 1980s and 1990s. Since 2000, however, yields have continued to decline, but stock valuation has fallen. This implies that stocks are priced to the assumption that yields will rise, future after-tax profits will decline, and/or tax rates will rise significantly.

This chart compares actual market capitalization (using the S&P 500 as a proxy) with a theoretical measure which capitalizes current after-tax corporate profits using the 10-yr Treasury yield as a discount factor. This model of equity valuation has worked pretty well for many decades, but has clearly broken down in recent years. One interpretation for this is that the market expects yields to rise, profits to fall, or tax rates to rise, or some combination of the three. However you look at it, though, the market is priced to some pretty big and unpleasant assumptions.

The VIX index of implied equity option volatility is a good measure of how nervous the market is. It typically peaks during market crises, as noted in the above chart. Today the Vix is trading around 18, which is substantially higher than the 10-12 level which has prevailed during periods of relative tranquility. This implies that the market is still pretty nervous, and that the future is still clouded by uncertainty (e.g., fears that tax rates will rise, government regulatory burdens will rise, and/or that the economy will suffer a relapse).

This chart compares the level of the S&P 500 with the Vix index (which is inverted, to show that a lower level of risk typically corresponds to a higher level of equity prices, and vice-versa). The Vix has returned to its pre-crisis levels, but the equity market has not, despite there having been a full recovery in corporate profits (in fact, after-tax corporate profits are currently at an all-time high).  This suggests that the market is still discounting profits at a higher-than-normal rate because of a general lack of confidence in the future.

This is a chart of the market's expectation for the level of the Fed funds rate one year in the future, as derived from Fed funds futures contracts. Currently, the market expects the funds rate to average just under 0.3% in Dec. '11. This implies that the market assigns a very high probability to the Fed keeping the funds rate target at 0.25% for all of next year. That, in turn, is likely to happen only if the economy remains relatively weak and inflation remains very low.

This next chart compares the yield on long-term BAA corporate bonds (blue line) with the earnings per share (i.e., earnings yield) of the S&P 500 (red line), as of Nov. '10. Earnings yields are now noticeably higher than corporate bond yields, a good indication that equity valuations are relatively cheap. (Normally, corporate bond yields should be less than earnings yields, since bonds are senior in the capital structure to equities and thus less risky.) After-tax earnings on the S&P 500 stocks now represent a "yield" of just under 7%, which also happens to be the average of the past 50 years. Corporate bond yields, in contrast, are currently 5.7%, which is 300 bps less than their average of the past 50 years. If it weren't for the market's expectation that after-tax earnings are very unlikely to maintain current levels, much less increase, stocks would be considered an incredible bargain by historical standards. Which is another way of saying that the market is assuming that profits will deteriorate and/or corporate tax rates will rise.

Gold traditionally has been a refuge from political, monetary, and economic risks. That it is trading at all-time nominal highs and close to all-time real highs is evidence that the market's perceived level of risk is unusually high.