Wednesday, May 25, 2011

Markets are still on edge, with room for improvement

This chart compares the implied volatility of equity and Treasury options, and it's not surprising that they have been highly correlated over the past 5 years, since they reflect two sides of the same capital market. Implied volatility is a good proxy for the market's level of fear, uncertainty, and doubt, and as this chart shows, FUD is still somewhat elevated compared to the relatively tranquil days of 2006 and early 2007. I take this to be an indication that the market is still conservatively priced, still somewhat concerned that something might go wrong, and not overly optimistic.

It's also not surprising that the return to conditions of relative tranquility has been slow and gradual and not yet complete. "Once burned, twice shy," as the saying goes; the memory of the recent recession is still vivid, and there are still lots of things to worry about (e.g., trillion-dollar deficits and a gigantic increase in the monetary base).

As fear continues to slowly fade, to be replaced by increased confidence, equity prices should gradually rise and bond yields should rise as well, because increased confidence will lead to more investment, more jobs, and a stronger economy. Low Treasury yields are the market's way of expressing deep concern about the economy's ability to grow, so higher yields should naturally accompany an eventual improvement in the economic outlook.


Bill said...


How good are these data points in predicting recessions? Didn't they show that things were pretty good right before the crash? In other words, they seem to change pretty fast with little warning.

Scott Grannis said...

I think a significant rise in implied volatility is one clue to an impending recession. Not a guarantee, but a strong clue. The Vix rose from 10 in early 2007 to a high of 30 in the summer of '07, well in advance of the recession onset. Ditto the Move index.

PerformanceSpeaksForItself said...

Don't you think there are reasons to be as cautious as these metrics show? Euro debt crisis unsolved, debt overhang from credit bubble, China slowing, ME unrest...plenty to worry about. I would be more bearish than bullish until these are cleared up...too much room for things to go wrong and collapse again.

William said...

Just reading the cautious and somewhat pessimistic comments of readers on this blog - and other blogs - tells one that there is a wall of worries amongst the investing public which as Mr. Grannis points out keeps equity prices reasonable. Personally I take these as good omens for equities.

I believe in letting others do the worrying for me. I become worried about equity prices when others are enthusiastic - and of course at such a moment, I am enthusiastic too.

When investing one should do the opposite of their own emotions - that's why it is so difficult

John said...

I am with William.