Monday, July 20, 2009

Fear subsides, prices rise (9)

Another update to this chart. The VIX index, a proxy for the market's fear (and the related uncertainty over the future direction of equity prices), has declined to a new post-crisis low, but equity prices seem very reluctant to rise. One explanation of this would be that while there is less fear and uncertainty about the direction of the economy, at the same time the consensus view calling for a slow and painful recovery has solidified. A depression has been ruled out, but the recovery doesn't look to be very impressive at all, to judge from the looks of the market. I think Obama's policies have been a significant factor in depressing investor enthusiasm, since they involve massive increases in government spending and thus huge increases in future tax burdens.

So from an investor's standpoint, the key question today is whether we see a very slow and drawn out recovery or something a little better. I'm in the latter camp, because I see improvement across the board in a number of important fundamentals, all of which I have discussed in the past few months:

Swap and credit spreads have declined significantly. Implied volatility in stock and bond options has declined significantly. Commodity prices are up signficantly (e.g., the CRB spot commodity index is up 24% from its December low, crude oil is up 47%, copper is up 88%). Currency growth has all but ceased (implying the end of declining money velocity). Residential construction has bottomed, and housing prices are probably at or near their lows. Weekly unemployment claims are down 23% from their high. Credit card delinquencies are down. ABS and CMBS prices are up. Used car prices are up 16% this year. Shipping rates and volumes are up. Corporate layoffs are way down. Corporate profits (the NIPA version) are still fundamentally healthy. The yield curve is very steep. High yield and emerging market bond prices are way up. Treasury bond yields are way up from their year-end lows. Core inflation measures have not declined meaningfully.

As I see it, the economy is recovering despite the best efforts of Obama and the Democrats to saddle the economy with huge new tax and regulatory burdens. The Fed hasn't helped either, with very erratic monetary policy over the years and now a monstruous increase in the monetary base that goes so far beyond anything we've ever seen that the average person can't possibly understand what is going on.

I've always been willing to give the economy the benefit of the doubt when it comes to recovery; I don't think you can underestimate the ability of this economy to overcome adversity. If it weren't for bad fiscal and monetary policy the economy would be booming by now. Instead it is probably going to grow about 3% a year for the foreseeable future, although that's not enough to make a huge dent in the unemployment rate.

If the current decline in Obama's approval ratings continues, if Obamacare fails to pass before the August Congressional recess (an increasingly likely outcome, thank goodness), and if the cap and trade bill gets postponed to next year, then the outlook could brighten considerably. It pays to be optimistic these days.


alstry said...
This comment has been removed by a blog administrator.
Public Library said...

As you can probably guess, I disagree Scott.

How an economy with trillions in debt, an unemployment rate 10%+, driven 70% by consumers, can average 3% GDP or more, would be nothing short of an act from God. And that does not even address Obamacare, Cap/Trade, and the future tax burden we will all face.

Risk measures are as meaningless as they were when China was buying every US security under the sun and the ratings agencies were slapping AAA on anything that brought in a fee.

I guess since the mortgage brokers have found jobs selling ways to decrease the debt burden they originally sold, we can now all go home and relax because the economy is on the mend.

Public Library said...

"Real" GDP growth that is...

Public Library said...

This just in!

"Goldman Sachs in Talks to Acquire
Treasury Department "

"Mr. Hestron said the only challenge facing Goldman in completing the merger "is trying to figure out which parts of the Treasury Dept. we don't already own."


Scott Grannis said...

Public: well, disagreements such as this are what make markets. We are just going to have to wait and see who's right.

Rick said...

Scott, the decline in volatility has also coincided with a decline in volume from April-May. In addition, open interest by commercial traders in SPX futures contracts is at a low point. Equity prices have risen almost 50%from the March lows. Also, consider Andy Kessler's column from last week's Wall Street Journal in which he cited the Fed's increase in the money supply as likely being a catalyst for equity investments. As the Fed withdraws money from the system, will the demand for equities remain high? Do not overlook the monetary aspect to this rally by dwelling upon the fiscal politics in DC. Regards.

Scott Grannis said...

Rick: the stats you cite sound to me like a market that is very reluctant to rally. That is one of the points of my post also. Prices are up 50%, but from levels that implied "the end of the world as we know it." The market has gone from pricing in a disastrous depression to now pricing in a very miserable recovery. I don't see that as a warning sign to investors or optimists.

I've said before that I think the Fed can withdraw their liquidity injections without creating a big problem for the market. If they were to pre-announce the conditions for an exit strategy, the market might actually be extremely encouraged to see money being withdrawn.

Almost by definition, the time to withdraw liquidity would be when prices of risky assets are rising, which in turn would signal the return of confidence and liquidity. The Fed would be selling into strength, and the fact of their selling should be interpreted by the market as extremely positive, as a confirmation that conditions were improving.

So I'm not worried about a Fed reversal. Indeed, I welcome it!

Daniel said...

Yes, I think prices are on the rise. Here is my real life example of it:

I went this morning to purchase an extended maintenance on my BMW, and on July 1st, BMW decide to increase the cost of the extended maintenance 36%!!!!! What would have cost me $1395 on June 30th, now costs me $1895.

Should I be outraged? Or is this a sign that things are getting better....hmmm

Public Library said...

Furlough days are in effect in CA and as I mentioned in a prior post, I know people this impacts and they have already taken measures to cut basic services and "niceties" to make up for the difference.

We will see another wave of consumer pullback in California, as for other states, I really do not know. I think the budget proposal/cuts are ultimately good for CA and the greater economy but that it will take years to work through the process of reestablishing a more balanced economy.

Scott Grannis said...

While the budget cuts in CA will hurt some, they won't hurt the vast majority of people. The best news is that the budget problem was fixed without higher taxes. Higher taxes would have made things worse, pushing more hard-working people and businesses out of the state.