Fear declines, prices rise

One more update to one of my favorite charts since late 2008. It reminds us that there are several things driving the stock market higher, and a decline in fear and uncertainty (represented by a decline in the Vix index) is definitely one of them. The Vix is still higher than it would be if calm, confidence, and tranquility reigned, but it is getting close to what might be considered "normal." Meanwhile, the return of confidence is being propelled by an improving outlook for fiscal policy (the debate now centers on how much spending to cut, not whether to cut spending or raise taxes); and an improving outlook for the economy (corporate profits remain very strong, manufacturing is improving dramatically, even the service sector is picking up).

The one remaining source of uncertainty is monetary policy. As the outlook for the economy improves, commodity prices continue to move higher, and the dollar languishes near its all-time lows, more and more people are calling into question the need for QE2. Shouldn't the Fed be pulling back already? Allan Meltzer had another good op-ed on this subject in the weekend WSJ, "Ben Bernanke's 70s Show," in which he concludes that

The Fed should make three changes. First, it should increase the short-term interest rate it controls to 1%, which would show that it is aware of the inflation risk and will act promptly to counteract it. Current low interest rates are an opportunity for the Fed to start reducing excess reserves.

Second, it should announce a specific, detailed plan that explains how it proposes to reduce about $900 billion of the more than $1 trillion banks continue to hold in excess of their legally required reserves.

Third, it should end QE2, its latest round of Treasury bond purchases. If, last November, the Fed had waited two more months before starting QE2, it would have known that a double-dip recession was not about to happen. Instead of waiting, the Fed responded to the cries coming from Wall Street.

So the world is still far from perfect, and there are still many things to worry about. But that also means that prices for risky assets are still likely somewhat cheap.