Friday, November 18, 2011

Markets are still priced to a very ugly outcome


This chart recaps the level of systemic risk in the U.S. vs. the Eurozone, using 2-yr swap spreads as the proxy. By this measure, the situation in Europe today is almost as bad as it was during the global financial panic of late 2008. But systemic risk in the U.S., though somewhat elevated, is still relatively low. Investors worry a lot about the possibility of contagion from Eurozone defaults, but in practice no one is demanding an excessively high premium to take on U.S. counterparty risk.


This chart compares the level of swap spreads to the average yield on junk bonds. Since Treasury yields have been extraordinarily low for some time now, the level of yields is arguably a better indicator than spreads for the actual difficulties faced by high-yield-rated companies. Both measures of risk are somewhat elevated, but they are nowhere near as bad as they were in 2008. The problems in the Eurozone are having only a modest impact on conditions here in the U.S., and investors are willing to accept counterparty and low quality credit risk for a relatively low premium.


This chart compares 5-yr swap spreads to spreads on 5-yr A1-rated industrial bonds. Here again we see that the premium necessary to convince investors to accept these risks is still relatively low.



Now contrast the relatively low levels of systemic risk and investor fear that can be found in the bond market to the very high level of fear that can be found in the equity market. The chart above shows the PE ratio of the S&P 500 compared to the 1-yr forward consensus view of earnings. Investors are only willing to pay a multiple of 11.7 times expected earnings, which is equivalent to saying that the expected earnings yield that investors demand in order to hold equity exposure is 8.5%. Investors today are almost as reluctant to hold equity exposure as they were at the end of 2008, when the global economy was in free fall and financial markets were terrified by the fear that the global banking system would collapse. The same analysis holds for Eurozone stocks (second chart above), although PE ratios in general have been much lower for European stocks then they have for U.S. stocks (presumably because the long-term growth outlook for Europe has for a long time been less robust than for the U.S.).


Circling back to the bond market, the level of 10-yr Treasury yields is extremely low, and is consistent with the view that the outlook for the economy is utterly dismal.

I'm not sure I have a good explanation for these disconnects. Spreads in the U.S. are priced to a modest level of concern, while spreads in Europe are priced to an extremely high level of concern. Treasury yields and PE ratios, in contrast, are priced to the gloomiest of outlooks. But however you look at it, there appears to be no shortage of pessimism in today's market pricing. In fact, optimism is very difficult, if not impossible, to find. AAPL, for example, has a forward-looking PE ratio of only 10.9 according to Bloomberg, which means the market is extremely skeptical of analyst's earnings projections. AAPL's current PE of 13.6 is only slightly higher than the S&P 500's 12.8, and this for a company that has grown earnings at a spectacular rate for years.

So I come back to the theme that has been dominant for the past three years: markets are very, if not extremely, pessimistic, and valuations are therefore very attractive if one believes that the U.S. and global economies are not going down the toilet. Even holding only a modestly positive outlook for the future makes one extremely optimistic relative to the outlook embedded in market pricing. By the same logic, being bearish today (i.e., hiding out in cash that pays nothing) is a very expensive proposition, and is likely to pay off only if the U.S. and global economy really get bad.

12 comments:

William said...

Thank you for your excellent charts and analysis. I always appreciate your efforts on our behalf. I believe that one day in the not to distant future your "theme" will pay off handsomely.

John said...

I second that, William!

Dr William J McKibbin said...

Everyone should be taking cover now...

Benjamin said...

Terrific wrap-up by Scott Grannis. As always, we are indebted to Scott for his chart presentation, insights, and platform for conversation, even if we disagree on some matters.

I wonder if on stocks, the market is moving to lower pe's long-term. After all, would you pay 10 times earnings for a bar? Yes, public companies can grow, but how assured is that? Bars can grow too, if they are in a growing part of the country.

How about $1 million for a bar that nets $100,000 in a growing part of Miami Beach? Seems a bit rich, no? Why pay more for Coke?

Public companies survive only as long as they are as good as the competition. They have a lease on life. And someday, that lease is up.

Add in Redleaf/Vigilante, that public companies have weak ownership. Maybe 10 times earnings is about right for a public company---although they can always be taken private, usually for about a 25 percent premium.

On the plus side, the world is awash in capital, and if stocks ever look like they are going to get hot, then they will get very hot. Capital comes in cascades into any promising sector. See commodities.

That same capital glut is holding down yields. This may be the new normal. Capital is abundant. It needs a home. If you want security and yield, be prepared to stand still.

Inflation is dead--that will also depress yields. See Japan. In the USA, we recently had a 30 percent run-up in energy costs (due to global oil markets), and core inflation was under 2 percent. You can't have too many 30 percent run-ups in energy. Core is going to head to subzero land in the future.

BTW: See those junk bond yields 2008-9? Who had the cast-iron stomach to buy?

William said...

McKibbin - You are obviously kidding us. Three weeks ago you wrote that you're "only problem" was that you couldn't find enough money to invest in this bargain market.

Oh!! - previously you wrote in July that the USA would default on it's debt. We need - well maybe not - to remember your predictions ;~)

Thanks for the humor.

W

Dr William J McKibbin said...

Hi William -- hopefully, everyone has already converted from cash into dividend and rent-paying equities, which I have been advocating now for over six months -- those who have not yet plunged into equities by now are probably too late -- but, that's just my opinion -- you should do what you think is right for you and yours -- however, when I see spreads in bonds like those in Europe today, then yes, I would say now is the time to take cover...

brodero said...

The world is offering 30 year money
to the U.S. at 3%....

John said...

Thinking about all this, why would the economy "take off?"

The labor supply is high, so wages will continue to sink for most. Any pick up in demand will force food and energy prices up, choking off any rally.

Maybe if you get an ISDA, you can make a fortune placing bets. For the rest of us, it's Vegas, baby.

Dr William J McKibbin said...

Hi William, you made the statement that "...previously you wrote in July [2011] that the USA would default on it's debt..." For the record, I did not write such a statement -- but, I am delighted that I am humoring you, thanks...

John said...

Brodero offers an astounding point:

"The world is offering 30 year money
to the U.S. at 3%...."

Doesn't that imply the global finanial system is a cesspool, figuratively speaking?

Frozen in the North said...

The question for North America is not if a recession will occur, but what are the mechanism that would allow for the transmission of risk from Europe to North America. That JPM revealed last week that it held $5 trillion in gross derivative exposure is a good example of risk -- what happens if the OTC counterparty goes bust. Another are European banks in America (DB is the biggest).

America has a self imposed debt crisis, taxation base could easily raised (I get the ideological problem people have with that), and that this would cause other problems...

Contagion is America's risk -- how well is America's financial system protected. Moreover, the odds of a TARP II are between Zero and nil, from the GOP, Tea Party, OWS and the Democrats, and the Banks insisting that 'everything is fine", there is no chance that aggressive action will be taken if one of Europe's banks fail!

Daniel said...

id buy some aapl here, and more on the way down..