Monday, December 22, 2008

The crisis is passing

These four charts represent different measures of the degree of fear that is driving markets these days. All show that fear has declined, and in some cases significantly. The VIX/10-yr ratio remains the highest, but mainly because the yield on 10-yr Treasuries has been driven to exceedingly low levels in part because of the Fed's recent vows to keep yields low for "some time" and to purchase Treasury bonds in order to drive down borrowing costs, neither of which has much to do with fear. (The other part of the reason for very low Treasury yields being the fear—or the expectation—of deflation.)

As fear subsides, liquidity is slowing picking up, and these are essential first steps towards recovery. All of this reinforces my belief that we are seeing a bottoming process in the equity and corporate bond markets.


jj said...

Great charts as always, most insightful! Saw an interview this AM with Mohamed El-Alarain (sp?) of PIMCO. He said that 2008 was the year of the financial and banking crisis and that 2009 will be the year of crisis for the broader economy.

He defined various asset classes as concentric rings with Treasuries at the center, with increasing risk as you move out from the center. He said you could buy assets away from the center but you want to stick to assets that are supported by the Gov't like mortgage backs, CP of say a GE, and debt of the big five banks.

He said you do not want to buy any asset class in the capital structure that is below where the Gov't might come in. With the collapse of Lehman Brothers the Gov't had no choice but to act but those actions introduced a great deal of uncertainty into the markets. The Gov't changed the rules and they may not be finished changing the rules.

He said he saw some improvement in the credit markets but he still saw the economy continuing to deteriorate through the first half of '09. I have been buying equities which is lower in the capital structure than he thinks is prudent but it seems to me that once the uncertainty is gone so also will the values.

Any thoughts would be appreciated.

Scott Grannis said...

So Pimco is only very cautiously bullish, only willing to buy the safe stuff. Will that work if the economy continues to deteriorate? Not sure. But if the economy stabilizes or improves, then they will miss out on incredible opportunities. Bottom line, with everyone pessimistic and with valuations so beaten down, you have got be very very bearish on the economy's prospects to adopt any kind of defensive strategy.

Randy R said...

Mohamed El-Erian managed the Harvard endowment, and is considered one of the best and "brightest" by many. I have no reason to doubt that. But one thing I've taken to heart is that being a genius doesn't protect anyone (see Long Term Capital Management, and all the idiot bankers now failing). Further, the new "Multi-Asset" fund that he manages and Allianz is touting has a 2.24% expense ratio! That's simply ridiculous. Especially if (as Pimco projects) future returns for all asset classes will be very dim, how can an investor possibly justify that expense? I think that reflects badly on Pimco's reputation.

Tom Burger said...

The financial panic is certainly dimishing, but the calming process doesn't have anything to do with the markets having appropriately priced risk assets. Instead, it's all about the government ensuring participants that it won't let anybody get hurt -- and the Fed deliberately manipulating treasury rates all across the curve.

I wonder how many people are thinking like PIMCO: put your money where you can count on a government bailout if necessary? Heck of way for an economy to allocate capital.

Meanwhile, in the real economy, we haven't actually seen the impact of all the layoffs and cutbacks that have been announced in the last quarter. As John Hussman says in yesterday's post: "Recessions are essentially periods where a mismatch arises between the mix of goods and services demanded in the economy, and the mix that was previously produced. In recent years, the huge trade imbalances we've observed have not reflected a sustainable mix, so dislocations have been inevitable."

Hussman is still feeling that the situation is "constructive" for the stock market because valuations are reasonable. I buy that, but I am concerned that correcting economic "dislocations" may take longer than normal because our government has so fundamentally altered the workings of the capital market and is about to further interfere with entrepreneurial incentives by attempting to "feed a 25 lb. turkey to a Pomeranian." (I love that analogy from the other post).

Tom Burger

Scott Grannis said...

Investors who buy into a balanced fund with a 2.24% expense ratio are the ones whose intelligence should be questioned.

Scott Grannis said...

Tom: I think risk assets have been appropriately priced. Equities and corporate bonds were priced to the expectation of a record-breaking depression, massive defaults, and many years of deflation. It's hard to imagine anything worse!

Have you seen the bounce in corporate bond funds recently? Check out HYG. I think that confirms what I'm saying.