Walls of worry persist

The market is still climbing walls of worry, and that's a good sign.

As I see it, here's the bearish case for equities: The Fed is no longer "printing money" and is soon going to begin to raise short-term interest rates. The market has enjoyed a great party for years, but the Fed is about to take the punchbowl away. Equity valuations are stretched, and earnings reports are turning mixed. The energy sector has been savaged, and there may well be nasty ripple effects: layoffs and defaults. China is in a slump and over-burdened with debt. Europe is in another slump and no amount of QE is going to make things better. Countries all over the world are trying to devalue their currencies in the hopes this will boost exports—but that's a fool's game. Policymakers have run out of tools to stimulate growth; growth is likely to be meager for the foreseeable future. The market's enthusiasm is likely to founder on the rocks of slow-growth reality.

In contrast, here's what I think the bullish case for equities is: QE was never about printing money; it was mainly about transmogrifying notes and bonds into T-bill substitutes in order to accommodate the world's demand for safe assets. Confidence is returning, however, and demand for safe assets is declining, so ending QE was the right thing to do. The economy still has plenty of unused capacity, but growth has definitely picked up in the past year. Congress is very unlikely to raise taxes, and may even succeed in lowering them, especially for corporations. Regulatory burdens are more likely to lighten than to increase further. Even if interest rates start moving up soon, they will still be very low relative to inflation for a long time. Equity valuations are no longer cheap, but relative to the yields on safer assets, equities still look quite attractive. There are still plenty of signs that the market is cautious, and that worries are more prevalent than exuberance. Absent a recession—which looks unlikely—equities are likely to outperform most other asset classes because of their superior earnings yield.

Here's how I read some of the more important market-based tea leaves:

The chart above represents the yield menu that investors have to choose from. If you don't want to bear any risk, you are not going to earn anything on cash. Cash (and cash equivalents such as 3-mo. T-bills) yields zero because the demand for safety is extremely strong. The market seems indifferent between owning equities with an earnings yield of about 5.5% and owning cash, with a yield of zero. That can only be taken as a sign that the market is still quite risk averse.

Risk aversion can also be seen in the chart above, which shows that spreads on corporate bonds have risen meaningfully from their recent lows. When confidence and the appetite for risk are strong, spreads are tight; that is not the case today. But doesn't the recent rise in credit spreads signal a coming recession? I don't think so, since swap spreads—the best leading indicator of economic and financial trouble on the horizon—are still quite low. Systemic risk is low, but there's still a lot of worrying going on, and that makes for a healthy market environment. The time to get really worried is when the market is priced to perfection. As it was in early 2000, when the economy was expected to grow 4-5% per year indefinitely.

The chart above shows that the market has been climbing walls of worry (worry being quantified here by the ratio of the Vix index to the yield on 10-yr Treasuries) for most of the past several months. The Vix index is high, which means investors are willing to pay up for the relative safety of options. The 10-yr Treasury yield is quite low, which means investors don't expect the economy to be very strong.

The chart above shows that the earnings yield on equities is significantly higher than the yield on 10-yr Treasuries. This is a clear sign that the market worries that the outlook for corporate profits is troublesome, to say the least. During times of strong growth (e.g., the 1980s), the earnings yield was well below the yield on 10-yr Treasuries. The equity risk premium has been unusually high for several years, during which time equity prices have marched continually higher. It's been climbing walls of worry all the way up.

The chart above compares the earnings yield on equities to the price of 5-yr TIPS (I use the inverse of their real yield as a proxy for their price). When the price of TIPS peaked in 2012, that was a sign of extreme risk aversion: the market was willing to pay a huge price for the relative safety of TIPS, which are default free and inflation-protected. At about the same time, the earnings yield on equities was also at or near a peak, which reflected great distrust concerning the outlook for corporate profits. In the past few years, demand for TIPS has weakened and confidence in the future of corporate profits has improved. But both are still far from where they would be in "normal" times. The market has become less fearful, but it is still somewhat risk averse.

As the chart above shows, it's unusual for the earnings yield on equities to exceed the yield on BAA corporate bonds, as has been the case for the past several years. Bonds are senior in the capital structure to equities, so they should normally yield more, especially since they don't have the upside price appreciation potential that equities do. Today's level of yields suggests that the market is still willing to "pay up" for the relative safety of bonds.

The prices of gold and 5-yr TIPS have been declining for the past two years, as shown in the chart above. (Here again I use the inverse of the real yield on TIPS as a proxy for their price.) Yet both are still high from an historical perspective. The demand for these two unique assets has weakened as the market has regained some confidence in the future, but they are still relatively expensive. The inflation-adjusted price of gold over the past century has averaged almost $600/oz., which is half of today's price. The average real yield on 5-yr TIPS since 1997 is about 1.4%, which is substantially higher than their current real yield of -0.2%.

As the chart above suggests, the real yield on TIPS should tend to track the real growth potential of the U.S. economy. GDP growth has picked up over the past year or so, and real yields have moved higher, both of which are good signs. But real yields remain quite low relative to the almost 3% rate of real growth over the past two years. That's a sign that the market is dominated more by worries than by exuberance.