Friday, February 22, 2013

Climbing little walls of worry

I hadn't been watching things very closely the last few days, and so I was shaken to see the market drop amid concerns that the Fed was likely to end its current Quantitative Easing program. But after looking at market fundamentals, I'm reassured that this is nothing more than a "little wall of worry" in the market's long climb to new highs.

If the Fed were going to accelerated its tightening timetable, then that should be reflected in a significant rise in 2-yr Treasury yields. The yield on 2-yr Treasuries is driven primarily by the market's guess as to what overnight rates will average for the next 2 years. Yet those yields have not budged on average for the past six months, and in the past few days they have even dropped a few basis points. Swap spreads are still very low and have not budged at all. So the bond market is not worried at all about a tighter Fed. The only sign of concern is the Vix index, which has jumped from 12 to 15, but that's not telling us anything about the economy, only about how worried investors are.

And even if the Fed were to begin raising rates sooner than expected, that is hardly a reason to worry. It's more logical to think that would be a good thing, since the Fed's current ultra-accommodative policy stance has created mountains of uncertainty about the future value of the dollar and inflation. Short term rates of 1, 2, or even 3% wouldn't pose a problem at all to the economy if it were a bit stronger than it is today, and there is almost no chance the Fed would raise rates if the economy were truly headed for a fall.

In the meantime, all the Fed is doing with its QE program is to swap bank reserves for bonds. It's not printing money, and it's not directly sustaining the equity market. Banks already have way more than enough reserves to support massive increases in lending. Financial market liquidity wouldn't begin to be adversely impacted until the Fed started aggressively draining reserves, and that won't happen for a long time.

What is sustaining the equity market is the realization that the economy is not doing as badly as had been expected. It's still growing, albeit slowly. The yields on non-Treasury securities are very attractive as long as the economy doesn't sink into another recession, and there is no sign of that about to happen.


William said...

I find it helpful to remember that there are all kinds of participants playing in the equity markets. The large institutions ultra-fast networks which can trade in fractions of a second based upon an algorithm; institutions just making a tactical move for a few hours because they expect the market to go down after quickly reading the FED beige book; individual day traders; those institutions and individuals who hold equities only a few days or weeks looking for a couple point move.

Short terms moves in either direction are usually driven by "news" - they are just squiggles. I find amusing the daily attempts by "financial writers" to explain each day's move up or down: every website and newspaper has someone with the duty to put something together. It must be a tedious job.

The really large and important big moves come when major unexpected news hits the market. Market participants generally do a really good job of anticipating the future - discounting the future - but look out when they get it wrong.

marcusbalbus said...

only you would see the good in a brutally overpriced market: tepid growth is not usually associated with historically high shiller pe; a fed controlled market is. good luck with your long positions once the rug gets pulled out.

Scott Grannis said...

Shiller's PE calculation, which uses 10 years of trailing earnings, has never made much sense to me.

L.A. said...

Shiller's PE is great academic work. However its usefulness as an investing tool is nonexistent as it is way too slow to respond in our rapidly changing world.

Who the hell cares what happened 10 years ago when making an investment decision today, other than marcusbalbus. You would seldom own any equities basing decisions on Shiller's PE. Good luck with that approach.

steve said...

scott, I gotta tell you that you scare me by ostensibly thinking you have any idea where the market is headed. I've been in the investment business for over 30 yrs and I can tell you the NO ONE prognosticates the markets well. I'm NOT forecasting a struggling market but I am smart enough to know that I don't know where the market is headed over any sort of time frame short of 20 yrs.

Gloeschi said...

Scott's logic:
How Vix = good
High Vix = shows how scared investors are = also good

Chris McFarland said...

@L.A. - Why do you say the Schiller PE is worthless as an investing (as opposed to trading) tool? I'm certainly no expert but I've seen studies that show a good correlation with Schiller PE and subsequent 10 year return. For trading it seems worthless, I agree, but I can't imagine why anyone would trade on a 10 year metric.

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