Friday, February 25, 2011

Gauging market sentiment -- still very cautious

The equity market has rallied some 25% since the end of last August, with only a few pauses or mini-corrections. Is it now overbought and vulnerable to a major decline? In order to answer that question I look at market-based measures of investor sentiment, which I survey below. I conclude that there is still a good deal of fear, uncertainty and doubt priced into the market. When I then look at the two dozen bullish charts I posted a few days ago, which paint a picture of an economy with fairly solid growth fundamentals, I further conclude that there is little or no reason to worry about a major correction or another bear market at this point. The time to worry about a big downturn in the market is when the great majority of people are convinced it won't happen, and when market-based sentiment indicators are priced to a high degree of confidence in the future. That is not the case today.

As this chart shows, consumer sentiment is on the rise, but from an historical perspective, it is still quite low. Consumers are still wary and worried about the future, even though the economy has recovered to some extent from the recent recession. Why? For one, the federal budget is in terrible shape; and unless big steps are taken to cut discretionary spending and halt the unchecked growth of entitlement spending (e.g., social security, healthcare), we will find ourselves in a world of hurt. Huge deficits, fueled by unchecked spending, threaten the living standards of all those who work, since government spending is inefficient—squandering the economy's resources—and at some point too much spending will result in a permanent rise in tax burdens. Two, the Fed's quantitative easing experiment is a huge foray into uncharted waters, and can only inspire great uncertainty about the future value of the dollar. Three, the across-the-board surge in commodity, energy, and gold prices seems likely to feed through to higher prices at the consumer level. In the face of these three facts, it would indeed be amazing if consumer confidence were at high levels.

Credit default swap spreads have come way down from their recent highs, reflecting a significant improvement in the outlook for the economy. But they are still substantially higher than they were in early 2007, when markets were calm and few questioned the economy's long-term fiscal and economic health.

This chart of the option-adjusted spread on corporate debt goes back farther in time but tells the same story: spreads are much lower today than they were two years ago, but they are still at levels that in the past have signaled impending economic distress, and they are still substantially above the levels that in the past have been associated with relative economic and financial tranquility.

This chart of the Vix Index—the classic measure of the equity market's fear, uncertainty and doubt—has also come down a lot from its recent highs, but it too is still trading at levels that are higher than what we have seen during periods of relative tranquility in the past. It's not significantly higher than what might be considered "normal," but the point I'm making is that it's not at or even close to all-time lows. Nobody today is arguing that the path to the future looks bright and free of risk. On the contrary, the list of things to worry about is long and well-known: federal fiscal profligacy, geopolitical tensions in the Middle East, Fed policy in uncharted waters, a president whose popularity is extremely low, a very weak dollar, soaring gold and commodity prices, and a severely depressed housing market. (Please add to the list as I'm sure I'm leaving something out.) The market, therefore, is still climbing walls of worry, and it shows.

What the Vix Index is to equities, the MOVE index is to Treasury securities: the implied volatility of options on Treasury securities across the yield curve. Like the Vix, this index has come down a lot from the distressed levels of a few years ago, but it is still above levels that in the past have been associated with relative tranquility. In short, the bond market is still somewhat nervous.

This chart shows the ratio of the Vix Index to the 10-yr Treasury yield. High levels of this ratio are a sign of great fear on the part of the market. A rising Vix clearly indicates rising fear, uncertainty and doubt, whereas a falling 10-yr yield is a good indicator that the market is lowering its expectations for economic growth. When the two happen together (thus pushing this ratio higher), it is a sign not only of rising fear but of faltering confidence in the economy. As with many of the other indicators, this one looks much better today than it did a few years ago, but it is still substantially higher than at times when relative tranquility has prevailed.

This chart is one of the few exceptions, since it shows that key measures of financial conditions are at levels that might be considered "normal."

This chart of 2-yr swap spreads is another of the few exceptions, since it suggests that financial market conditions are normal and systemic risk is quite low. A skeptic might argue that swap spreads are low because the Fed is extremely accommodative and by inference prepared to do anything and everything possible to ensure that the economy gets back on its feet and we avoid another banking crisis; by inference, if the Fed were to withdraw its support, things might deteriorate rapidly. That is a fair criticism, but it only bolsters the argument I'm making, which is that the market is not ignoring the risks that lie ahead.

This chart compares the earnings yield on stocks (12-mo. trailing earnings divided by the current share price) to the average yield on long-term BAA-rated corporate debt. It is rare for earnings yields to exceed bond yields, since bond holders are senior in the capital structure to equity owners, and thus have first claim on the earnings. Note that earnings yields exceeded bond yields for several years in the late 1970s, a period that can only be classified as one in which fear, uncertainty, and doubt were extremely high. At the very least, I think this chart provides evidence that the equity market is nowhere near an "overvalued" condition, as—in hindsight—it was at the end of 1999.

This chart is simply the inverse of the EPS (red line) in the previous chart. The point here is that PE ratios are below their long-term average (a sign that investors are unwilling to pay up for a dollar's worth of earnings), and far below where they were prior to the 2000-2001 equity market collapse. Again, it is very tough to argue from this that the market is overpriced or overly-optimistic.

The earnings used in the previous PE calculation are based on reported, 12-mo. reported earnings. In the chart above, I'm using the most recent annualized measure of economic, after-tax corporate profits as reported in the National Income and Products Accounts. NIPA profits are considerable stronger than GAAP profits, and using NIPA profits shows that the market's PE ratio is substantially lower than its long-term average. In fact, it's almost as low today as it was in the early days of the great bull market rally that began in the early 1980s, which, of course, followed a period of great uncertainty and pessimism.

On an inflation-adjusted basis, and relative to a large basket of trade-weighted currencies, the dollar is trading at its lowest level ever. A very weak currency is a classic sign of a lack of confidence in a country. Indeed, the dollar at current levels is signaling that investors worldwide have a great deal of concern about the future of our economy. Contrast this to periods such as the early 1980s and the runup to 2000, when the dollar was very strong, and optimism was widespread.

This chart shows the market's expectation for the level of the Fed funds rate one year in the future. (The last datapoint of 0.42% means that the Feb. '12 Fed funds futures contract is priced to the expectation that the funds rate will average 0.42% during that month.) That the market is only expecting one tightening from the Fed between now and next February reflects expectations that the economy will be struggling to advance for at least the next year. No sign whatsoever of any optimism here.

With the exception of the very first chart above, everything I've shown here is an indicator of market sentiment that is driven by data—not by surveys or anything that might be considered subjective. Although the charts aren't unanimous in their message, on balance I think they at least rule out any suggestion that financial markets are overly optimistic. Indeed, I believe these indicators confirm that that there is still a healthy amount of caution and concern embedded in today's equity prices. For those who believe we can overcome the difficulties that lie ahead, the market would appear to be very attractively priced.


John said...


Another excellent post.

For those with the tolerance for some volatility it is not too late to participate in this bull market. It may well have years not months of life. My guess is years. There will be corrections/pullbacks and fear will reappear occasionally but high quality large US companies with overseas exposure and good histories of growing dividends are a good place to look. Do some diligent homework and if you are patient and ignore the pessimistic macro heads you should be well rewarded over time.

Benjamin Cole said...

Another tour de force by Scott Grannis.

I quibble with only one statement---that consumer confidence reflects QE, and the possibly related rise of commodities prices. (I am not sure I count gold as a commodity, due to its strange power over men's minds).

My guess is that consumer confidence is tied to the job market and job security and growth in real after-tax wages.

There is a suggestion out there that we have a "plutonomy," that means the wealthy are such a large portion of consumer sending, that if the wealthy are not confident, then spending will be weak. Could be--it was Citigroup that launched this idea, not some left-wingers.

Still, I think a solid job market will heal all wounds. Bring on the recovery, the bigger the better I say.

Japan's feeble monetary response to slack demand has not worked, and has had decades to work, but still hasn't.

Better "too much" stimulus and growth than not enough.

Cabodog said...


The depth of your posts (and your commitment to share) always astound me. Thank you.

Christian S. Herzeca, Esq. said...

great post scott, a real tour de force.

i agree with much of your post, but having your analysis and depth research makes me feel much smarter. :>)

i bought this dip on the third day of libya malaise. we will see how things go, but i too believe that the secular bull is still in place, at least until the fed stops buying bonds.

as a side note, i have to report something extraordinary. cramer made me some money. i was watching his mad money at the gym on the first day of the dip, and i was inclined t buy the next day, but cramer said, paraphrasing, that dips usually last at least 3 days so don't go back in yet. normally, i discount cramer heavily, but this made sense to me and i held my fire until the end of the third day. wonders never cease.

Buddy R Pacifico said...

An outstanding post. I appreciate the extra effort given to going back over many years in the charts when possible.

William said...

Thank you, Scott Grannis!

Been reading your blog for 8 months and I am extremely impressed with the depth of your knowledge and analysis. Your August post of two dozen charts refuting the Double-Dip theory was not only timely but also very helpful for me personally.

Curious: Scott, were your methods able to detect the fateful "credit bubble" building in 2005 - 2008? Could you provide me a link to an old blog post which discussed it? I would love to read it.

Thank you,,,William

Scott Grannis said...

William: I only started the blog in Sep. '08, so I can't point you to any brilliant insights I might have had prior to the housing bust. But people who know me from my Western Asset days can attest to the fact that prior to '06 I was expecting housing prices to fall 30-35%, and I thought credit spreads and implied volatiilty were way too low to be sustainable. I remember many meetings in which I would repeat that something bad was waiting to happen, but I just didn't know what it was. I confess to not ever having any idea how bad the housing collapse would turn out to be, even though I got the magnitude of the price decline correct. I did not sell everything in advance of the crash.

My colleagues at Western shared my views, and we took what we thought were very reasonable precautions against a big decline in housing prices. But again, we were totally unprepared for the fiasco that occurred.

septizoniom said...

another blinkered post. all price signals are completely distorted by unprecedented money creation and interference by the federal reserve.

Public Library said...


At point does a sinking dollar cause major issues for the US and global economy?

Scott Grannis said...

Re the sinking dollar: I suspect it is already causing issues for many countries. Everyone is trying to keep their currency from appreciating further vis a vis the dollar. So monetary policy is easy almost everywhere. All currencies are sinking against gold and commodities. Conclusion: inflation is going to be rising in most countries.

William said...

Thank you for your honest response, Scott. I enjoy and appreciate your Blog!