Tuesday, February 19, 2013

Having vanquished fear, the market is now ready for optimism

Back in November 2008 I first highlighted the link between the market's fears (using the Vix Index of implied equity index option volatility as a proxy) and the level of the S&P 500, and I've been updating the chart below regularly ever since. It now appears that fear no longer plays an important depressing role in equity prices. 


The Vix soared in the latter half of 2008, and that presaged the market's coming collapse. Then as fear slowly faded, in fits and starts, over the past four years, the equity gradually recovered, climbing "walls of worry" all along the way. Now the Vix is almost back to the "normal" levels that prevailed in early 2007, and the S&P 500 is only 3% shy of the high it registered in October 2007. After 5 agonizing years, we've come almost full circle.

Does this mean the market is now optimistic? No. I think it means simply that the market is no longer afraid of the future; uncertainty spawns fear, but uncertainty and fear have now declined significantly. Equity prices have risen as fear has subsided; the future has turned out not to be as bad as the market had feared. Now it could be said that while the market no longer fears the future, the market nevertheless is not very optimistic about the future. Fear has been replaced by a confident lack of optimism. The market is in a sense comfortable with the idea that the future is not going to be very bright, and indeed could prove to be rather dull and even quite disappointing. 

I suspect that, having moved from being obsessed by fear to now being rather confident that nothing much will happen in the future, the market is ready to enter what is likely to prove a period of slowly rising optimism. With nothing left to fear, the market will be forced to focus on the facts. If the economy proves to do better than the market's dismal expectations, then the prices of risk assets can only rise. As I said in a post last month, "avoiding a recession is all that matters."

If I'm right, and the economy does avoid a recession, this has enormous implications for financial markets and for the economy.

Applying my thesis that fear of the future has been replaced by confidence that the future will be disappointing, here's how I read the market tea leaves today. The yield on cash is essentially zero, 10-yr Treasury yields are a mere 2%, 5-yr TIPS real yields are a miserable -1.6%, and the S&P 500 has a PE of only 15 (equivalent to an earnings yield of 6.6%). That all ties together if you assume the market (in its true collective sense) is confident that the U.S. economy won't be growing much in the years to come. Investors are comfortable owning TIPS and Treasuries at these levels because they don't believe that corporate profits will rise in coming years; indeed, the market is priced to the expectation, I believe, that profits will fall. Why own TIPS with a negative real yield—which guarantees a loss of purchasing power—unless you think alternative investments will deliver disappointing/negative returns? Why keep tons of money in cash (there is almost $7 trillion in bank savings deposits) unless you think that other assets that currently offer much higher yields will decline in price?

I suspect that, as long as the economy avoids a recession, and non-cash and non-Treasury investments continue to underperform the returns on risk assets, people increasingly will review their current asset allocation and conclude that they are being too conservative. They are passing up much higher-yielding alternatives because their assumptions about the future have been proven too pessimistic. People then will attempt to move money out of cash and into just about anything but cash: into real estate, corporate bonds, stocks, and commodities. I doubt that gold will be a major beneficiary of this, however, since in my view gold is still priced to something like a calamity occurring (e.g., hyperinflation, global economic collapse). If we instead just experience slow growth then gold will probably decline. The attempt to move out of cash and into riskier assets will cause the price of riskier assets to rise, and their yields to decline. Eventually, the Fed will be forced to raise the yield on cash until market expectations come back into some sort of equilibrium.

Some might call this a "market melt-up" scenario. Whereas waves of fear and panic drove equity prices to unbelievable lows in early 2009, the return of optimism could spark reflexive equity purchases that eventually drive prices to unsustainable highs.

25 comments:

William said...

Wall Street Journal !! finally !! catches up with Scott Grannis:

Investors Finally Shed Fears

Google this title and you can read the journal article for free!

sgt.red.blue.red said...

Yes, I'm happy to see that Berkshire Hathaway Cl. A has broken out to a new (nominal) all-time high, on Friday-Tuesday.

With about 35 percent more 'earnings power" than it had at the old December, 2007 high.

There is much more upside, in that the x book is about 1.34 and at the market peak in 2007 traded at almost twice book. That fifth of my portfolio is firing on all cylinders.

marcusbalbus said...

the market cannot collectively "move out of cash". such error in reasoning impugns all of your writing.

marcusbalbus said...
This comment has been removed by the author.
Scott Grannis said...

marcusbalbus: I've addressed this issue before so I don't know why I'm wasting my time with your petty nit-picking. Note that I said " The attempt to move out of cash and into riskier assets will cause the price of riskier assets to rise, and their yields to decline."

Of course the cash will remain even if there is massive buying of stocks with cash. It is the ATTEMPT to reduce cash balances that causes a change in relative pricing.

Gloeschi said...

But why would the attempt to reduce cash ever stop?

John said...

As a regular readed of this blog for many years I can attest that Mr. Grannis's market judgement has been excellent. The end-of-the-worlders and pessimistic macro heads are forever with us. Regular readers of these comments know who they are. Those who have paid close attention to Scott's suggestions and acted accordingly should be very happy....as am I.

Benjamin said...

Interesting wrap=up by Scott Grannis.

Well, don't forget the Fed is doing $85 bil a month in QE. Open-ended, based on results, not a set sum (like QE1 and QE2).

This is pushing money into assets, or spending.

Still, inflation is too low.

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theyenguy said...

Scott, in my article, An Investment Demand For Gold Will Arise On Competitive Currency Devaluation, I write the following:

The Sovereignty of Liberalism is at its zenith. And the US is Liberalism’s Premier Sovereign. The US, the second of two iron legs of global hegemonic power since the late 1700s, is as President Obama just finished speaking in the State of the Union Address, manifesting Peak Hegemony.

The adoption of the Milton Friedman Free To Choose Floating Currency Regime has produced Liberalism’s Peak Credit, Peak Currencies, Peak Nation Investment, Peak Global Production, Peak Stock Wealth, Peak Central Bank Wealth, and Peak Sovereignty, pretty much in that exact order.

Dollar Hegemony is at its peak, as Allan Sloan communicates in Fortune Magazine article The Fed’s Big Dollar Gamble. Ben Bernanke’s low interest rate policy has driven down the dollar; the Fed’s keeping-lowering-rates program doesn’t have an an indefinite shelf life. The bottom line is that pharmaceutical stimulus is forever; but Fed stimulus isn’t. It’s as Ron Paul, in Lew Rockwell, writes we are seeing The End Of Dollar Hegemony.

New sovereignty, new sovereigns, and new sovereign wealth is coming on the unwinding of the Euro Yen Currency Carry Trade, that is the EUR/JPY, together with competitive currency devaluation. These two agents will destroy, firstly fiat wealth, secondly the traditional cohesion of the EU as witnessed by the rising level of protests, such as the reported by the Euro News YouTube report Anti-austerity protests on Portugal’s streets, and thirdly, the global hegemonic power of the US.

Inflationism turned to Destructionism on Valentines Day, February 14 and on Friday February 15, 2015, as World Stocks, VT, Commodities, DBC, joined Bonds, BND, in turning lower on the exhaustion of the world central banks’ monetary authority and resulting inability to stimulate global growth and corporate profitability, as well as on the dynamic that the monetary policies of the US Fed, the ECB, the BoJ, and the PBOC, have crossed the rubicon of sound monetary policy, and have turned “money good” investments, bad.


The chart of the S&P 500 Weekly, $SPX, SPY, crested February 11, 2013, at 152.11, in an Elliott Wave 5 High. And World Stocks Weekly, ACWI, crested January 28, 2013, at 50.34, in an Elliott Wave 2 High. Nifty Charts writes Weekly $SPX chart has hit a crucial resistance line

Ryknow of PositiveExpectedValue(You) writes This is an equity rally driven by one simple factor: the growth of debt. In this entry I will show charts and give explanations that should leave very little questions on why I see the end results of this being a flight from capital markets. It has been the most heavily ended stocks which have drawn strong investor interest; these include, Diversified Equipment Manufacturer, GE, Paper Producer, IP, and Dig and Dirt Moving Stock, MTW, Rubber and Plastics Manufacturer, CSL.

It has been the Dividend Paying Stocks Excluding Financials, DTN, that is the first of two factors underwriting Nation Investment, EFA, Small Cap Nation Invesment, IFSM, Global Producers, FXR, Emerging Markets, EEM, and other yield bearing instruments such as VNQ, and REM, as is seen in the combined ongoing Yahoo Finance Chart, of DTN, EFA, IFSM, FXR, EEM, and VNQ.

And more importantly, the second factor in underwriting such wealth has been trust in the Distressed Investments held by the US Federal Reserve, that were taken in under QE1, such as those traded by Fidelity Investments FAGIX, and exchanged for “money good” US Treasuries; it is these that have been the basis for Liberalism’s expanding wealth and Dollar Hegemony. But the Distressed Investments topped out January 22, 2012, portending a turn lower in all forms of fiat wealth.

After a soon coming Financial Apocalypse, that is a credit bust and financial system breakdown, two forms of sovereign wealth will manifest under Authoritarianism; these being personal possession of gold and the other diktat.

Cabodog said...

Thanks Scott. Excellent post.

Interested in your current thoughts on AAPL; perhaps a separate post when you have time.

William said...

RE: FEAR DRIVES THE MARKET
Tuesday, November 11,2008

I remember that period well. What struck me as most interesting was what fears you identified: "ongoing housing crisis and Obama's policies (e.g., higher taxes, bigger government, trade restrictions, union expansion)". What I clearly remember as the greatest fears were the credit bubble which resulted in a credit crisis centered on bad derivatives and CDOs and the insurers thereof. No one knew who held the really bad derivatives doomed to fail: banks insurance companies, pensions funds, foundations, governments? And there was a serious concern about the ability of private insurance contract being able to pay. According to Warren Buffet and the CEO of GE, the credit markets for commercial paper froze in October. Hank Paulson and Ed Bernanke were in the fore.

The future president Obama was just getting up to speed and didn't make any comments until late December although a Paulson biography noted that Obama frequently telephoned him for updates and analysis.

From my conservative and libertarian friends, I received numerous hair-on-fire emails about the future Obama presidency. Shortly after the market bottomed on March 9, 2009, I sent a moderately optimistic email about the markets (perhaps your column) and received this replay: "As long as Obama is president the economy can't recover."

Almost to a man, these conservatives and libertarians sold almost all of their equity positions and bought bonds, annuities, CDs, and money market funds. And they still own them having not bought any stock over the past 5 years. They let their extremely strong political "beliefs" override all of the economic data including many of your essays which I sent them.

Not since the Salem Witch Trials have beliefs done so much damage.

Scott Grannis said...

William: thanks for the color and context. As you know, I never liked Obama and have argued all along that he is doing all the wrong things. But that hasn't deterred me from liking the market and the economy. I still think he is making grievous mistakes, but I think that in the end the U.S. economy is stronger than he is and will win out.

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Pragmatic Investor said...

I hope once and for all you explain why you keep saying market expectations for economic growth are dismal. Where do you get that idea and exactly what rate of economic growth is the market expecting?

William said...

Pragmatic Investor

Scott explains his views on your questions on a regular basis. Search the past Blogs - with an open mind.

Pragmatic Investor said...

Just because treasury yields are low doesn't mean people have low expectations on economic growth. From what I have read, that's all he's basing his claim on. And he could never quantify exactly what dismal expectations the markets have for growth.

marcusbalbus said...

what about the attempt to move into cash by the sellers?

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