Tuesday, May 31, 2011
When everyone's optimistic about the prospects for the economy and financial markets, you've got to think twice before becoming optimistic yourself. Likewise, when the market is pessimistic, bad news is priced in and that gives optimists a cushion, or room for error. The market is full of clues as to whether its optimistic or pessimistic, if you just know where to look. Here's a quick recap of some key indicators which all suggest that the market is clearly pessimistic about the economy's ability to grow, about corporation's ability to sustain profitability, and about the Fed's ability to stimulate the economy.
The first chart, above, shows the level of yields on 2- and 5-yr Treasuries, and the spread between the two. Yields and spreads have a predictable pattern as the economy moves through the business cycle. Yields typically rise in advance of a recession, because every recession since WW II has been caused by a tightening of monetary policy which, in turn, was motivated by the Fed's desire to reduce inflationary pressures. Tight monetary policy pushes up short-term interest rates more than longer-term interest rates, with the result that the yield curve flattens in advance of recessions, and usually inverts (i.e., when short-term rates are higher than longer-term rates, that is a good sign that a recession is on the way). Once a recession hits, the Fed begins to ease, and short-term interest rates fall faster than longer-term rates; the yield curve steepens. Following a recession it typically takes a few years before the market and the Fed realize that a recovery has set in. The Fed then gradually raises rates and the yield curve gradually steepens.
This time is no different. We are still in the early stages of a new business cycle, and the market and the Fed remain quite doubtful about the economy's prospects. The yield curve is still quite steep, and short-term rates are as low as they have been in many decades. 2- and 5-yr Treasury yields are dominated by the market's expectation of future Fed policy, so for them to be this low implies that the market expects it will take a long time before the Fed starts to raise rates, and when they do, it is likely to be very slowly. That, of course, means the market holds out very little hope for a robust recovery any time soon. The market seems to be screaming that the Fed is "pushing on a string," and that monetary policy is virtually powerless to stimulate the economy and/or to push inflation higher.
This next chart shows the level of option-adjusted spreads on corporate bonds, arguably the best measure of the market's expectations of corporate defaults. As this chart shows, spreads are still elevated from an historical perspective, and about at the same level today as they were a couple of years following the 2001 recession. Spreads are still substantially above the levels that prevailed during the optimism that permeated all markets in 2007. Today's spread levels are consistent with a market that is still quite concerned that a weak economy (and possibility lingering deflationary pressures) will threaten the viability of corporate borrowers in coming years.
Similarly, the Vix Index of implied equity option volatility remains elevated, and is still substantially higher than what we see (e.g., 10-12) during periods of relative economic and financial market tranquility. It's not alarmingly high, of course, but that is not to say that the market is not concerned about the future.
This next chart is quite impressive, since it shows that the yield on long BAA corporate bonds (which comprise the majority of investment grade corporate bond issuance) is lower than the earnings yield on the S&P 500. This is a rare occurrence, since it means the market would rather accept a lower yield on bonds (which do not participate at all in a rising equity market, but have first claim on profits) than take the risk of the higher total returns that normally accrue to equity owners, who today are able to fully participate in the upside in addition to "earning" a higher yield. This can only mean that the market is unusually skeptical about the ability of corporations to sustain current levels of profitability. Looked at from a different perspective, corporate profits are very close to all-time highs, both nominally and as a % of GDP, but since PE ratios are below average (15.3 vs. 16.7) the market apparently assumes that the outlook for profits is dismal.
In short, if you are at all optimistic about the future, or just less pessimistic than the market, then equities offer attractive valuations.
Posted by Scott Grannis at 3:57 PM