Monday, December 6, 2010

Assessing the market's assumptions

In order to have a view on whether the market is attractive or not, it's essential to consider the assumptions that are reflected in market pricing. What follows is a review of a variety of key market-based indicators that provide insights into the assumptions the market is making about the future. Taken together, these indicators suggest that the market is still quite cautious and concerned about the future. Nowhere is there any indication that the market is priced to optimistic or rosy assumptions about economic growth, inflation, interest rates or corporate profits. Indeed, most indicators reflect a market that is already discounting a deterioration in corporate profits, sharply rising yields, and/or higher corporate tax rates. What this suggests is that if the future turns out to be less problematic than the market is expecting, then there is still a lot of upside potential in equity prices.

This chart compares the spread on 5-yr swaps (a measure of the credit risk of generic AA-rated banks) to the spread on 5-yr A1 Industrial corporations (a measure of the credit risk of generic industrial corporations). Swap spreads have been trading at "normal" levels for most of this year, but industrials are still trading at levels that are elevated in an historical context. This means that the market still worries (not a lot, but more than it would if the outlook were healthy) about the viability of large industrial corporations over the next several years. 

This chart compares spreads on high-yield bonds to spreads on investment grade corporate bonds. Credit spreads are a good measure of the perceived default risk of corporate debt, and are generally correlated to the health of the economy—spreads tend to rise around recessions, and fall during recoveries. As the dashed green lines show, the current level of spreads is substantially above the levels that have prevailed during economic expansions. This implies that the market is still quite skeptical of the economy's ability to thrive.

Credit default swaps tell a similar story to that of credit spreads in general: the market's perception of default risk is still substantially higher than it was prior to the onset of the 2008 recession.

In theory, the price of a stock is the discounted present value of its future after-tax profits, and thus a function of three variables: interest rates, tax rates, and profits. Therefore, there should tend to be an inverse correlation between the level of yields and the price of a stock; the higher the level of yields, the greater the discount on future cash flows, and vice versa. This chart shows how the value of stocks (the blue line, which is the ratio of the S&P 500 index to nominal GDP) compares to the level of 10-yr Treasury yields (the red line, which is shown with the y-axis inverted). When yields were low and relatively stable in the early 1960s, the economy was strong and stocks were well-priced. As yields rose in the 1970s, stock prices fell relative to GDP, and subsequently rebounded as yields declined in the 1980s and 1990s. Since 2000, however, yields have continued to decline, but stock valuation has fallen. This implies that stocks are priced to the assumption that yields will rise, future after-tax profits will decline, and/or tax rates will rise significantly.

This chart compares actual market capitalization (using the S&P 500 as a proxy) with a theoretical measure which capitalizes current after-tax corporate profits using the 10-yr Treasury yield as a discount factor. This model of equity valuation has worked pretty well for many decades, but has clearly broken down in recent years. One interpretation for this is that the market expects yields to rise, profits to fall, or tax rates to rise, or some combination of the three. However you look at it, though, the market is priced to some pretty big and unpleasant assumptions.

The VIX index of implied equity option volatility is a good measure of how nervous the market is. It typically peaks during market crises, as noted in the above chart. Today the Vix is trading around 18, which is substantially higher than the 10-12 level which has prevailed during periods of relative tranquility. This implies that the market is still pretty nervous, and that the future is still clouded by uncertainty (e.g., fears that tax rates will rise, government regulatory burdens will rise, and/or that the economy will suffer a relapse).

This chart compares the level of the S&P 500 with the Vix index (which is inverted, to show that a lower level of risk typically corresponds to a higher level of equity prices, and vice-versa). The Vix has returned to its pre-crisis levels, but the equity market has not, despite there having been a full recovery in corporate profits (in fact, after-tax corporate profits are currently at an all-time high).  This suggests that the market is still discounting profits at a higher-than-normal rate because of a general lack of confidence in the future.

This is a chart of the market's expectation for the level of the Fed funds rate one year in the future, as derived from Fed funds futures contracts. Currently, the market expects the funds rate to average just under 0.3% in Dec. '11. This implies that the market assigns a very high probability to the Fed keeping the funds rate target at 0.25% for all of next year. That, in turn, is likely to happen only if the economy remains relatively weak and inflation remains very low.

This next chart compares the yield on long-term BAA corporate bonds (blue line) with the earnings per share (i.e., earnings yield) of the S&P 500 (red line), as of Nov. '10. Earnings yields are now noticeably higher than corporate bond yields, a good indication that equity valuations are relatively cheap. (Normally, corporate bond yields should be less than earnings yields, since bonds are senior in the capital structure to equities and thus less risky.) After-tax earnings on the S&P 500 stocks now represent a "yield" of just under 7%, which also happens to be the average of the past 50 years. Corporate bond yields, in contrast, are currently 5.7%, which is 300 bps less than their average of the past 50 years. If it weren't for the market's expectation that after-tax earnings are very unlikely to maintain current levels, much less increase, stocks would be considered an incredible bargain by historical standards. Which is another way of saying that the market is assuming that profits will deteriorate and/or corporate tax rates will rise.

Gold traditionally has been a refuge from political, monetary, and economic risks. That it is trading at all-time nominal highs and close to all-time real highs is evidence that the market's perceived level of risk is unusually high. 


Benjamin Cole said...

Wow! A terrific wrap-up by Scott Grannis.

Caution is the byword of today's investors. B. Wary is thy name.

I think this excellent collection of charts, especially the one pertaiing to market caps and profits, suggest a sustained bull market on the horizon. I have been saying this for a long time. Sooner or later, I will be right. So I will keep saying it.

anonimoXXX said...

In my opinion we are in a transition from a profoundly eskeptic market to an optimist market. But this process will take a lot more months.

Your ratios agree with my vision of the psicology of the market.

John said...

On August 25th Scott made a post called "20 Bullish Charts". The SPY exchange traded fund was at 1040 and the Russell 2000 ETF symbol IWM was at 59. As of today's close the SPY is 1227 up 18% from the time of Scott's August post. The IWM is up a scorching 28% to 76.

Scott took some heat for being bullish but he was right. I strongly suspect he is right again. This time next year the market will be higher...perhaps MUCH higher. And I suspect the same folks who were critical in August will be critica today. But that's OK. Its differences of opinion that make markets.

More excellent work from Mr. Grannis.

septizoniom said...

how do you assess your own assumptions?

honestcreditguy said...

easy road for equities to rise when you have hot money coming in from hedge funds borrowing overnight from the fed..

The market is a casino..nothing more...Without QE1&2 all these charts would be reversed....throw in FASB denial and all I see is insolvent companies and a last gasp effort to save pensions, spectulators and greed...

John said...

I might have asked you the same thing....but I didn't.

Public Library said...

Bernanke stated on National television he is 100% certain he can control inflation.

Inflation is already here and Bernanke's track record of predicting the future is horrific.

The markets should pay more attention to the man at the helm because the ship is headed for a titanic size iceberg.

Michael Meyers said...


Thank you for all the great charts! You're great.

Benjamin Cole said...

Public Library-

Given your views, why did Japan not have inflation 2001-6, when it had both QE and fiscal deficits?

Why is Japan mired in deflation to this day?

What could Japan do to exit deflation?

Why are property and equity values down 75 percent in Japan in the last 20 years? Is that a good result? Is that a result we should have in the USQA?

Public Library said...

I believe much of what happened in Japan had to do with demographics. Demographics create titanic shifts, albeit gradually.

This offset much of what the government tried to do. Their situation seems dire to me. I think Japan is headed for one heck of a train wreck when the tide eventually turns.

My guess is massive inflation too. The elderly will eventually spend the saved loot + how else do you think the government will repay their obligations?

Some say Bernanke is playing a game of blink with China to get them to un-peg. This is our cold war.

Sadly, he is pillaging our country to do so.

Benjamin Cole said...

Public Library-

S&P hitting new highs today.

Let's hope Bernanke continues with his pillaging, and throws in some marauding and plunder too.

Wake me when you see serious inflation in Japan. Me, and Rip Van Winkle.

Public Library said...


Your short-sightedness is exactly why we are here and the reason will repeat this experience in the not so distant future.