Tuesday, November 11, 2008

Fear drives the market

The ups and downs of the market continue to be driven by fear. The Vix Index is a good proxy for the market's fear, as it measures the implied volatility of equity options, and that in turn is an indication of how much risk the market sees in the future range of outcomes. This chart suggests that the equity market is depressed because the level of fear is inordinately high. Once fear subsides, then prices should drift higher.

Fear is high because the market worries about the combination of the ongoing housing crisis and Obama's policies (e.g., higher taxes, bigger government, trade restrictions, union expansion) pushing the economy into a depression. In short, the market is behaving as if a perfect storm is approaching, with little hope that we can avoid a catastrophe.

In order to keep the market at these levels, or to push it further down, the housing crisis needs to continue and/or Obama has to deliver the market- and economy-unfriendly policies that investors fear. If there is any sign of a bottom in housing or if Obama pays any attention at all to what the market is telling him (remember how Rubin convinced Clinton to respect the bond market), fear will subside and the market will rise.

I've been worried about Obama's policies all along, but I think the chances of him implementing a series of economy-killing policies at this point in time in order to comply with liberal orthodoxy are not very high. Obama's future chief of staff, Rahm Emanuel, was one of the key players in the early Clinton years, and he knows what can happen if you push an aggressive policy agenda. The stakes this time are even higher, and so the Obama administration would be well-advised to tread lightly and pay all due respects to the market.

Still, we need to wait awhile to see what happens. In the meantime, how long can investors ignore the huge prospective returns now promised by stocks and corporate bonds? If things don't get worse, there are huge gains there for the taking. You are being paid a lot to take risk these days.


pcpb participant said...

Chinese Stimulus:

Although I have never been a fan of government-fueled stimuli, the relative wisdom of the plan hinges on the source of funds the Chinese government decides to utilize. Their best choice would be the country's nearly $2 trillion in foreign reserves, the largest portion of which is held in U.S. Treasury and agency debt. This pile of dollars, which really amounts to no more than a subsidy for U.S. consumers, does nothing to benefit Chinese citizens.

If it does decide to employ this ocean of cash, China will become a net seller of U.S Treasuries just as the U.S. Government itself will be pushing up its issuance of new Treasury bonds into record territory. With two huge sellers and few major buyers (just about every major creditor nation having problems of their own), the Federal Reserve will become the only reliable customer. As a result, not only will the Fed monetize our own economic stimulus packages, but will be forced to provide the same service to the Chinese.

-by Peter Schiff, Euro Pacific.com

pcpb participant said...

Another source of "fear," your word.

Many red flags waving at the US stock market.



Scott Grannis said...

We don't know much about the details of the Chinese stimulus package, but I think you are right in pointing out that it could be financed at least in part by the sale of a significant quantity of Treasury bonds.

Accumulating a vast store of reserves in its central bank has had some beneficial impact on the chinese economy, however. It has made the yuan a rock-solid currency and that in turn has kept inflation relatively low. Low inflation and a stable currency are key ingredients for healthy growth according to the supply-side playbook.

So what happens if they sell a bunch of Treasury bonds? It might push US interest rates higher, but I think the more important thing is that it would boost the US economy. How is that, you ask? Simple: if you sell US bonds you have to spend the dollars you receive on something. Ultimately those dollars have to be spent on US goods and services, and that means a big surge in US exports.

The Fed might decided to buy those bonds, thus monetizing more of the government's debt, but that remains to be seen. If the economy is enjoying surging demand for exports, the need for the Fed to keep interest rates low would be radically diminished.

So the only way that China can boost its economy by drawing down its reserves is by also boosting the US economy. More good news.

When there are red flags waving everywhere and bad news is the only thing that gets people's attention, that's when you know it is time to think different.