Thursday, October 6, 2011

Panic update

The Eurozone sovereign debt crisis has struck great fear and trembling into the hearts of investors around the world for the past several months. Fearful that defaults could lead to bank failures, and bank failures to a global financial market collapse, and financial collapse to another global recession or even depression, investors have been willing to pay almost any price to escape the consequences of what might prove to be the "end of the world as we know it." Following is a quick recap of how the key U.S. indicators of investor panic stand at the moment. Bottom line: fear remains intense, but there are some preliminary indicators that conditions are no longer deteriorating.

Yields on 3-mo. T-bill have fallen to zero. Investors are willing to accept no return on their money in exchange for acquiring the world-class safety of T-bills. The last time this happened was at the end of 2008 when risk-aversion was at extremely high levels and the world was braced for a massive depression.

Yields on 10-yr Treasuries have fallen to their lowest level on record, lower even than the lowest yields in the time of the Great Depression, and lower even than the terrible lows that occurred at the end of 2008, when there was a widespread perception that a global calamity was in the making. Yields this low only make sense if you expect the future growth prospects of the U.S. economy to be downright grim, if not totally depressing. It is somewhat encouraging, however, to see that yields have appeared to stabilize in the past few weeks.

As I explained last month, it appears that about $400 billion of deposits fled the Eurozone banking system in favor of the U.S. banking system beginning in mid-June. The good news, as shown in this chart, is that this apparent run on Euro banks has run its course. M2 surged at an unprecedented annualized pace of as much as 40% in early August, but over the past four weeks, M2 growth has settled back down to a mere 4.6%.

Corporate bonds have been victims of massive, indiscriminate selling which has driven option-adjusted credit spreads to levels only seen during times of outright economic recession. Since there are no signs yet of a recession, much less of any rise in corporate default rates, this is just one more sign of how markets have panicked. In effect, the bond market is pricing in a pretty serious recession. Whether that proves to be the case is the key issue for investors today. If the economy manages to avoid a recession, corporate bonds offer extremely attractive risk/reward characteristics and very substantial yields—the current yield on HYG (a popular indexed high-yield bond portfolio), for example, is 7.75%.

The forward PE ratio on the S&P 500, shown in the above chart (i.e., current prices divided by one-year forward consensus earnings estimates) has plunged from almost 14 to just under 11, a decline of over 20% in the amount investors are willing to pay for a dollar of future earnings. This ratio was a just under 10 at the height of the Lehman panic in Oct. '08, and it is a bit higher today than it was at the stock market bottom of Mar. '09. This, despite the fact that corporate profits today are at all-time record highs in real, nominal, and GDP-relative returns, having more than doubled from their year-end 2008 levels. This therefore represents an extreme degree of pessimism in regards the future, with the market essentially forecasting not only a recession/depression, but a monster collapse in corporate profits. As with corporate bonds, if the economy experiences anything short of a major recession, equities offer extremely attractive risk/reward characteristics. The current earnings yield on the S&P 500, for example, is 7.8%.

Gold is sharply off its recent high, having fallen $300/oz. last month. But looked at from a long-term perspective, gold appears to be following a constant upward growth rate averaging about 20% per year over the past 10 years. Commodities have also suffered a correction of late, but they remain at very elevated levels from a long-term perspective. The recent corrections in gold and commodity prices undoubtedly reflect liquidation of speculative positions, as speculators "pull in their horns" faced with the sudden onset of deep uncertainty about the monetary, financial, and economic growth fundamentals. When investors rush for the T-bill exits, not many speculators are willing to hold on to leveraged positions at historically high prices.

Wrapping things up, what we are witnessing today is nothing short of a mass and extreme panic. Prices and expectations have reached historically extreme levels which have rarely been seen in the past. That's the bad news. The good news is that given the extreme degree of pessimism and panic that has been priced into the market, we can reason that it would probably take an outright catastrophe—something like the collapse of Western civilization—to not only vindicate the market's fears, but to reward those who currently stand on the bearish side of expectations. With that said, I remain comfortably on the side of the optimists because I can't bring myself to believe in, or speculate on, the end of the world as we know it. There are a lot of unknowns surrounding the Eurozone debt crisis, but there are also many things that can be done to avert a catastrophe. I don't think this is the time to throw in the towel.

UPDATE: According to Mervyn King, Governor of the Bank England, "This is the most serious financial crisis we’ve seen, at least since the 1930s, if not ever. We’re having to deal with very unusual circumstances, but to act calmly to this and to do the right thing." If there's any comfort after hearing those words, it's that the market seems to have already figured this out.


Benjamin Cole said...

Interesting wrap-up by Scott Grannis.

One troubling aspect of global trade and international capital markets---we in the USA become vulnerable to the poor policy choices of others (as if we don't have enough of our own).

This idea that the global financial system is not resistant to shocks, such as AIG, Lehman Bros., or Long-Term Capital Management, or now Greece, is not reassuring.

Either through markets or regulation, we need much more rugged financial systems.

McKibbinUSA said...

Microsoft is "on sale" at $26.34/share -- companies that are extremely profitable are selling at less than a third of their former values -- check out CPLA at $30.70/share, which is a company with revenues increasing at 10% annually even now -- the world is on sale!

William said...

UPDATE on Market Psychology:

Schaeffer's Investors Intelligence:
As of October 5, 2011, the percent Bears are 45% - significantly above the 38% reached at the August 2010 stock market bottom. The Bulls are 34%.

Lipper Funds Flows reported that equity mutual funds and ETFs had withdrawals of $5.9 Billion for the weeks ending October 5th and also September 28th.

For Lipper's latest reported month, August, 2011, equity fund outflows were $26.3 Billion. Interestingly, taxable bonds funds and ETFs are experiencing outflows as well - $18.9 Billion in August.

hlfjmf said...

It is simply amazing that at times like these logic takes a back seat to pure emotion. Everyone is now a technical analyst. As a retail broker and portfolio manager for mssb, I hear and see things the retail investor feels. The world has ptsd from the 08-09 war. The fear is palpable.

Benjamin Cole said...

"The fear is palpable."

If true, then buy, buy, buy.

Frozen in the North said...

The Dexia mess could easily get out of control. That bank (already 35% gov't owned after the 2008 crisis) has Euro 500 billion in Assets. Leverage of 60:1 (yep that's twice Lehman) and Euro 20 billion exposure to PIIGS (funny enough until last week it didn't make the list of the 15 most exposed banks to the PIIGS).

The other aspect is that Dexia is not a "normal" bank, the bulk of its business is to lend to governments...

This morning the IMF said, Europe has a few weeks before this become a disaster with massive bank failure. Now, I'm no fan of the IMF, bit this is rather dire.

On a final note, and maybe with some hope vis-a-vis the U.S., Canada's September employment numbers came out this morning. We were hoping for +16k jobs for the country, we got +60k instead... That's as if the U.S. had created 600k jobs (adjusting for economic size).

The issue for America is not America's economy (which seems to be surviving ok) rather is the risk that European contagion could hurt domestic financial institutions. The counterparty risk here is the issue not the underlying trade...