Tuesday, January 10, 2012

Climbing walls of worry: update

There are two ways of looking at the upward progress of equity prices since last summer. For optimists, who see the glass as half full, the market is gradually shedding some of the panic that gripped the world when the risk of Eurozone sovereign debt defaults started to look inevitable. For pessimists, who see the glass as half empty, the market is once again levitating on the fumes of optimism, poised to crash once again as the global economy collapses in the wake of Eurozone defaults (or the second down leg of the US real estate market, or the collapse of the Chinese economy—or all three, take your pick). I'm in the optimists' camp, of course, because as I have been pointing out repeatedly there is plenty of evidence that the market is priced to some dire expectations. Like all true bull markets, this one has been climbing walls of worry for most of the past three years. This is not a market driven by optimism, it's a market that has had to overcome several major bouts of fear and trembling in recent years, and it's still plenty worried about the future.


To begin with, this chart shows how the level of unemployment claims—a proxy for the underlying health of businesses—has been leading the equity market higher. Businesses are firing fewer and fewer people because they have cut costs to the bone, leaving them well-prepared to cope with any future adversity. You can't have a legitimate rally if the fundamentals are not improving.


The Vix index, which measures how much investors are willing to pay to reduce their risk (because it reflects the cost of owning options, which is less risky than owning the assets underlying the options), is a good proxy for the market's level of fear. As the above chart shows, major selloffs in equity prices have typically been driven by increased fear, and rallies by decreased fear.


But even though the Vix has dropped significantly from last summer's peak, it is still elevated from an historical perspective. Plus, 10-yr Treasury yields, which are a good proxy for the market's expectation for long-term economic growth, are still trading at extremely low levels—lower even than at the end of 2008 or during the depths of the Depression. The combination of the two, shown in the chart above, reflects a market that is still somewhat fearful, while having given up almost all hope for a return to decent economic conditions. Call it fearful despair. Moreover, there is still plenty of room for fear and despair to fade away, before we might say that the market has become priced to something resembling optimism.



As the first chart above shows, the PE ratio of U.S. stocks is still at very depressed levels. That PE ratios can be substantially below their long-term average at a time when corporate profits are booming (after-tax corporate profits are now at record levels both nominally and in terms of GDP) can only mean that the market is priced to the expectation that profits will collapse in coming years.

In conclusion, the market is still priced to very pessimistic assumptions about the future. What this means for investors is that lots of very bad and terrible things would have to happen to undermine the current level of valuations. If the world can just avoid another calamity, then risk asset prices can continue to rise.

20 comments:

Junkyard_hawg1985 said...

At today's ^vix level (20), the market is in the normal area for worry. When the ^vix drops below 15, we are in the fat, dumb and happy area. I don't buy that the ^vix/treasury ratio accurately predicts fear. It is a) manipulated by the fed and b) not predictive of real fear. When real fear sets in, the yield increases. People start demanding more from their money when they are worried. It become the Twain quote: "The return OF your money is more important than the return ON your money."

That said, I actually use the ^vix for buying and selling. When the ^vix exceeds 40, I buy. When it drops below 20, I sell half of my buy. When it drops below 15, I sell the second half. So far it has worked well. I did pull the trigger eqarly today when the ^vix hit 20.05. A 15% return in 5 months was a good return.

Benjamin said...

Superb commentary by Scott Grannis.

I wonder if lower-than-historical PEs might be the new normal, given shareholder realization that long, long periods of sideways slosh are possible. And creative destruction, and the inherent weakness of shareholders (see Vigilante/Redleaf).

That said, corporate profits are headed north. The private sector produces more with less every year, in opposition to federal agencies, that produce lels with more every year.

Squire said...

The resistance high was set Oct. 27and today closed just about there. A breakupwards may get lots of people climbing on board the moving train. People invest mostly based on what they think other people will do. Right now I think there are a lot of would be buyers. On the margin, the next buyers need to at least see stomping and snorting. Later buyers need to see the herd stampeding.

Kurt said...

Speaking of walls of worry, I just saw the news bit in WSJ that German bonds are selling at a negative yield. Not merely a real (inflation-adjusted) negative yield, mind you, but an honest to God nominal negative yield. That's some kind of fear!

Scott Grannis said...

Re German yields: with the exception of the 1-yr note, German government bonds of all maturities have a positive yield, ranging from 0.3% for 3-mo. bills to 2.5% for 30-yr bunds. The 1-yr has a very slight negative yield of 0.008%. As is the case with Treasuries, these very low yields are a sign that investors are extremely risk-averse.

Squire said...

I am fearful. I trade, I don’t invest. It appears to me that the U.S. economy cannot operate, let alone thrive, without increased debt and stimulus, AND, that we have reached the end of debt of stimulus. I am fearful we are left with Benjamin’s solution, inflation. But my first comptroller job was during the late 70s early 80s stagflation so I don’t accept inflation will work.

Benjamin said...

Squire-

I am proposing moderate inflation and robust growth---not bad stagflation! But thanks for noticing that I post.

The option is Japan. If we do a Japan, short equities, short real estate, and invest in bonds.

AusGarry said...

Re Japan - any views on the truth of the lost decades (google The Myth of Japan’s Failure - Fingleton). Could be that demographic changes and pricking of monumentla asset bubbles (that mean that previous highs may never be reached) disguise the fact that Japan has done relativley ok.USA better demographics may mean that fear is misplaced except for those who bought in close to asset high points.

CFP, EA said...

Japan's failure has always been a somewhat specious argument. If you look at real GDP growth, then, yes, the past 20 years have been terrible. If you look at the Nikkei, then, yes, it's been a disaster.

So, in a sense, for investors, the past 20 years has been a disaster.

However, if you look at real GDP per capita, things have been a bit slow, but hardly a disaster. And given the falling working population, the growth in real GDP per capita has been amazing. (Now, how much of that was created by the country's massive debt will be discovered soon enough when the aging Japanese people begin to sell their gov't bonds. This will force the Japanese government to get their funding from abroad, which could raise rates, which likely will force the gov't to reduce its deficit.)

What worries me about Japan is not so much what will happen to the regular people. With increasing real GDP per capita, they should be alright. No, the Japanese example isn't that scary for normal workers; it's scary for investors, like us! Aging, shrinking populations seem to cause stagnate corporate profits and very little to negative equity returns.

Given that that Japan's demographics are so similar to Europe and, to a much lesser extent, the United States, that's a huge concern. Are investors in developed stock markets in for low returns as those population age? I don't know. But the Japanese experience doesn't bode well.

CFP, EA said...

Japan's failure has always been a somewhat specious argument. If you look at real GDP growth, then, yes, the past 20 years have been terrible. If you look at the Nikkei, then, yes, it's been a disaster.

So, in a sense, for investors, the past 20 years has been a disaster.

However, if you look at real GDP per capita, things have been a bit slow, but hardly a disaster. And given the falling working population, the growth in real GDP per capita has been amazing. (Now, how much of that was created by the country's massive debt will be discovered soon enough when the aging Japanese people begin to sell their gov't bonds. This will force the Japanese government to get their funding from abroad, which could raise rates, which likely will force the gov't to reduce its deficit.)

What worries me about Japan is not so much what will happen to the regular people. With increasing real GDP per capita, they should be alright. No, the Japanese example isn't that scary for normal workers; it's scary for investors, like us! Aging, shrinking populations seem to cause stagnate corporate profits and very little to negative equity returns.

Given that that Japan's demographics are so similar to Europe and, to a much lesser extent, the United States, that's a huge concern. Are investors in developed stock markets in for low returns as those population age? I don't know. But the Japanese experience doesn't bode well.

Dr William J McKibbin said...

@Squire, now is not a great time to trade, but rather to invest -- high quality dividend and rent-earning equities are now a bargain for investors with a 15-25 year investment horizon...

Dr William J McKibbin said...

PS: I fear dark times descending upon Europe -- more at:

http://wjmc.blogspot.com/2012/01/teutonic-versus-latin-banking-regimes.html

I know that Scott believes that European bond defaults have already been priced into the market -- that may or may not be so -- take great care with evaluating the effects of sovereign bond defaults in Europe -- the wild card in that assessment is the potential for civil unrest, or even changes in governments and regional violence...

Dr William J McKibbin said...

PPS: I am also concerned about what will happen in California -- Gov Brown appears determined to raise taxes, which is a hard sell at best -- if taxes go up as he plans, California's private enterprises will begin to react much as they have in Illinois -- conversely, if Gov Brown fails to get a public mandate for tax increases (which is likely), then hundreds of thousands of state workers will likely become unemployed -- I do not see how California is going to navigate through its budget issues without significant disruption to the California economy -- so again, California remains on my radar as a worry not only for California, but for Federalism at large...

Dr William J McKibbin said...

Errata: the number of state workers that could be effected by a California budget cut would be in the tens of thousands vice hundreds of thousands, thanks...

Donny Baseball said...

Not only are corporate profits strong, but balance sheets are at their healthiest in a loooong time by any measure (vs. equity, assets, cash flow). Equity holders today get a huge safety benefit for free on top of decent earnings flowing to them.

We are close to upending traditional corporate finance orthodoxy - that govts are risk free and private enterprises demand a premium. Corporations have shown themselves to be flexible, responsive and fiscally prudent while govts, well, have not. I would rather own the common stock of P&G over, say, the state of Illinois's bonds any day.

Investors stampeding into "risk-free" assets in search of safety are in for a rude awakening. Whether they conclude that equities are a better bet is an open question, but certainly it's gonna be on their minds.

Dr William J McKibbin said...

@Donny Baseball, I completely agree -- dividend paying equities are my safety net these days -- I do not like to invest in paper I cannot understand, and I increasingly do not understand sovereign debt issues -- in fact, I am terrified of sovereign debt these days -- at least when I own a commercial building filled with renters, I know that own that building -- the same with owning income stocks -- sovereign bills, bonds, and notes now carry extreme levels of default risks -- our state capital in Harrisburg (Pennsylvania) is in default on its bonds for example --the ownership rewards from bonds are simply not enticing, at least for me -- my big "worry" as Scott describes the emotion is the risks of civil unrest in Western civilization as we know it -- civil instability a risk that I do not know how to mitigate...

L.A. said...

Thank you for your services, Scott. Do you employ any sort of valuation technique to the SP500 to determine over/under pricing? Or do you merely take the sum of the parts (ie the charts/trends) to determine the direction of the market.

As you and others have noted, and as we see everyday, economic health and direction doesn't necessarily translate into investment earnings on equities. At least not in the short term.

Scott Grannis said...

I look at valuations from a long-term investor's perspective. Today the standard measures of valuation (e.g., PE ratios), in the context of record-high profits, tell me that the market is priced to extremely pessimistic assumptions about future growth. My outlook is substantially more optimistic than the market's, so I see stocks as being very cheap.

Bill said...

Scott,

Can you comment on Schiller's method of valuing stocks which concludes that stocks may in fact be expensive?

Scott Grannis said...

Re: Schiller's valuation methodology. He calculates PEs using 10-yr trailing earnings. I fail to understand how earnings from so many years ago can be relevant to what is going on today. So many things can change in 10 years (inflation, accounting practices, economic cycles, etc.) that I really question whether the results of this calculation are meaningful when applied to today's data.