Fear subsides, prices rise

I must have shown this chart at least a dozen times since late 2008, but it is so important that repetition is justified. (Here is a post from May '09 as an example) The main message here is that fear was the key driver of the 2008-2009 recession: fear of a global depression, fear of a global banking collapse, fear of deflation, and fear of a huge increase in future tax burdens thanks to an equally huge increase in the size of government. Fear drove us to the brink of what was expected to be an awful depression, and the reduction of fear is putting us back on a growth track.

The correlation between fear (represented by the red line, the Vix index inverted) and equity prices that is evident in this chart speaks for itself. The Vix has now returned to its pre-recession levels, and equity prices are on track to do the same, though the S&P 500 will need to rise another 25% to recover its previous highs.

Fears have been assuaged relentlessly since March '09. Swap spreads narrowed sharply. Credit spreads narrowed sharply. Signs of a recovery displaced expectations of a depression. Public reaction to the stimulus plan was mixed. Obama's popularity began declining, and the implementation of his agenda started facing headwinds. The Fed took strong action to expand the money supply. Financial markets began healing instead of collapsing. Commodity prices and gold prices started rising. Global trade got back in gear. Since the recession ended 18 months ago, the economy has proven the skeptics wrong more than once, and the forces of recovery have been working steadily behind the scenes, albeit slowly. Housing stopped collapsing and started stabilizing. A sea-change in the mood of the electorate resulted in a huge change in the congressional balance of power; the private sector now has a friend in Congress, and capital once again is held in high regard. More recently, a major increase in tax burdens was avoided, and a gargantuan omnibus spending bill went down in flames.

Short-term interest rates have been essentially zero for two years now. Investors, faced with the steep cost of safety (i.e., accepting a zero return for the safety of cash) have been realizing that the risks were not as great as they once feared, and they have been slowly deploying their cash hoards. Fearful investors have climbed countless walls of worry along the way, only to see the prices of risk assets moving higher. Consumers have been slowly drawing down their cash hoards, with the result that retail sales have now made a complete recovery. The next shoe to drop will be when corporations begin deploying their immense cash hoards to fund expansion plans and new hiring.

 It's hard to see how this self-reinforcing process of recovery can be derailed.