Thursday, November 15, 2012

Reading the market tea leaves: lots of bad news is priced in

As the world waits to see how politicians figure out how to avoid the looming "fiscal cliff," nerves are on edge. Even though the risks of failure perhaps might not be high, the consequences of failure could be very serious. Moreover, politicians might avoid the fiscal cliff but still implement policies (e.g., sharply higher tax rates on small businesses, the engine of jobs growth) that could hamstring the economy.

Now is a good time to look once again at key market indicators that can help us understand how much bad news is already priced into the market. As I see it, the market is already braced for an unpleasant outcome to the fiscal cliff negotiations. That's not to say that we should expect an unpleasant outcome, but rather to say that should the outcome be unpleasant, that would not necessarily be bad news.

The above chart compares the real yield on 5-yr TIPS to the running 2-yr annualized growth rate of real GDP. The underlying premise of the chart is that government-guaranteed real yields that are available for purchase in the TIPS market can tell us a lot about the market's expectations for real economic growth. If I buy a 5-yr TIPS bond today, I have locked in a risk-free real rate of return of -1.4% per year for the next 5 years. Don't be quick to dismiss the importance of this; TIPS prices are not distorted. The spread between 5-yr TIPS real yields and 5-yr Treasury nominal yields is just over 2%, which means that the market is expecting the CPI to average about 2% per year for the next 5 years, and that is not unreasonable at all, considering that the core CPI has risen at an annualized rate of 1.7% over the past 5 years, and the CPI has increased at a 2.1% annualized rate over the same period.

Apparently the market is quite content to lock in a guaranteed loss of purchasing power with TIPS. I think that only makes sense if you accept that the market is willing to do this because there is a lot of fear out there that buying and holding any riskier asset is likely to mean real returns in coming years that are disappointingly low. By inference, if the market expects real returns on risk assets to be very low (perhaps even negative) over the next 5 years, then the market also expects the real growth of the economy to be very disappointing. That's precisely what the above chart shows: the current level of TIPS yields is consistent with real GDP growth that is close to zero over the next 5 years. That could be variously interpreted of course: it might mean 2 years of recession followed by 3 years of a moderate recovery, or it could be just total stagnation.

Note how in the chart real TIPS yields do a pretty good job of tracking the growth rate of the economy over the past 15 years. When economic growth was robust in the late 1990s, TIPS yields were very high; and with growth rates slipping to the current 2%, TIPS yields have declined.

And it's not just the bond market that is pessimistic. As the chart above shows, the stock market's confidence in the stability of earnings has also tracked the real yield on TIPS. As the real yield on TIPS has fallen over the years (shown here inverted), the earnings yield on the S&P 500 has risen (and the market's PE ratio has fallen). Why would the market today be priced to an earnings yield of 7.3%, when real yields on TIPS are -1.4%? The only way that makes sense is to accept that the market is demanding a very high equity earnings yield today because it expects earnings to be much lower tomorrow. If the market had any confidence at all in the stability of earnings going forward, then PE ratios would be higher (at least above their long term average of 17) and earnings yields would be lower—at least below the current 4.5% yield on BAA corporate bonds.

CDS spreads tell the same story. Credit default swaps are a very liquid market and a very good indication of the market's confidence in the future health of the economy. CDS spreads today are at the same level they were just prior to the onset of the Great Recession. The market is obviously concerned that default risk is relatively high, and that only makes sense if the market also worries that the economy might experience another recession. 5-yr high-yield bonds are trading with yields that are 6 percentage points higher than 5-yr Treasuries because the market thinks that there is a significant risk that corporate defaults will be troublesome in the years ahead, and that is only likely to happen if the economy is very weak.

When 10-yr Treasury yields are trading at extremely low levels (these bonds have almost never been so expensive), it's a safe bet that the world is very risk-averse.

And it's not just the U.S. that is in trouble, according to market expectations. As the above chart shows, sovereign yields in the U.S. and Germany are converging on the yields of that paragon of miserably slow growth, Japan. The market is behaving as if the world's major developed countries are going to be experiencing the same stagnate growth as Japan, which has suffered zero net growth since the end of 2006 (as compared to 4.4% growth in the US over the same period) and annualized growth of only 0.7% over the past 10 years (as compared to 1.6% in the US over the same period). Note also, for comparison purposes, that 5-yr real yields on Japanese inflation-indexed bonds are -0.6%. Negative real yields and extremely low nominal yields all point to one thing: a market that expects agonizingly slow growth to prevail—much slower than we have seen in recent years.

If extremely low 10-yr Treasury yields are symptomatic of miserably low real growth expectations, and if the Vix index is a good proxy for the market's level of fear, then the ratio of the Vix index to 10-yr Treasury yields (shown in the chart above) is a good indicator of how worried the market is about  the future level of growth. The Vix/10-yr ratio has spiked during every major crisis in the past few decades, and although it is significantly lower today than it was at the height of the 2008 meltdown—when the market fully expected a global financial market collapse and years of depression and deflation—it is still extremely high by historical standards. In short, this indicator suggests that the market is quite fearful of another recession.

Finally, the above charts show how investors are voting with their feet. Equity mutual funds continue to experience heavy outflows, while bond funds continue to experience strong inflows. This is a picture of a market that is very worried about the future and very concerned about seeking shelter.

If there is one thing out of place in this picture of a market obsessed with concerns about growth, it is swap spreads. Swap spreads have been excellent coincident and leading indicators of the fundamental health of the financial market and of the economy. As the chart above shows, swap spreads rose well in advance of each of the last three recessions, and declined well in advance of the onset of recoveries. Today swap spreads are unusually low, which is telling us that the fundamentals of the economy are not in the least shaky. Systemic risk—actual risk as perceived by market participants—is very low. The wheels are not about to come off this economy. The best explanation for why so many indicators point to troubles ahead but swap spreads say everything is fine, is that the market is very worried about something that has not yet even begun to happen. And it might not happen, either, if swap spreads are still good leading indicators.

In short, as I see it, the market is priced to lots of bad economic news that has yet to hit the tape. The market may end up being right, of course, but there are reasons to think that the market may be too pessimistic. At the very least we know that the market has had plenty of time to work itself into a frenzy of concern, since there is no shortage of things to worry about: political gridlock in Washington, a president who is anti-business and anti-wealth, trillion-dollar deficits for as far as the eye can see, a Middle East in turmoil, a huge increase in regulatory burdens, the onset of ObamaCare—which promises wrenching adjustments for one-sixth of the nation's economy, millions of underwater mortgages, and monetary policy that is far advanced into uncharted territory, to name just a few. It should not be surprising or controversial to discover that, in a time bad news is in plentiful supply, that the market is priced to pessimistic assumptions.

If you're worried about the future, you have plenty of company. If you're seeking refuge and protection, it's extremely expensive. The world is braced for lots of things to wrong. As I mentioned last August, it might make sense instead to worry about something going right.


Gloeschi said...

"If you are seeking protection, it's extremely expensive"

Implied volatility in April 2013 SPX puts is now lower than on September 13 (QE3 announcement).

Spot VIX is below 20.

That's not "extremely expensive"

McKibbinUSA said...

The markets are definitely priced for economic horrors -- that means dirt cheap prices -- now is the time to buy -- now is the time to get your share of the pie -- now is the time to invest for the long-haul in dividend and rent-earning equities!

Scott Grannis said...

I'm referring to the protection of cash and/or Treasuries, which are indeed extremely expensive because of their extremely low yields. Vix is not extremely high, but it is significantly higher than the "normal" level of 10-15.

Gloeschi said...

Recession is not priced in (or it would be the first recession where EPS keep growing). Fiscal cliff = tax increases = less in consumer pockets = recession.

brodero said...

As always a great summation by Mr. Grannis...

Benjamin Cole said...

If the Fed insists on asphyxiating the economy, you will get

1. Slow growth
2 Very low interest rates due in part to
3 Very low inflation, and very low inflationary expectations...

Milton Friedman said it best; If you have low interest rates, that is a sign that money has been tight and is expected to stay tight.

Back when I took econ 101 (or was it 102), back in the gas lamp era, we learned that printing too much money leads to inflation.

Not taught was what happened if you did not print enough money.

The not enough money problem happened after my school days. It was called Japan, and still is.

Add to that, the United States.

The rest is jibber-jabber. Dems or GOP, cutting the budget or not. You tell me who would runs smaller deficits when in power: The Dems or the "deficits don't matter" GOP? Man, I don't know.

The Fed has got to get aggressive.

McKibbinUSA said...

Keep an eye on the stock market, which seems to be in correction -- the last time we saw stock prices break the trend line, the correction amounted to 17% -- we are still looking at downside opportunity -- now is the time to sell your car, take on a third job, or have a garage sale in order to create investment capital to buy super cheap stocks in the secondary markets -- forget IPO's and forget growth -- look for companies that are eager to pay dividends and buy with abandon -- the values on the stock market are rampant right now -- more at:

Value investors with a 30-year plus horizon are very happy right now...

Public Library said...

We should be careful about assigning the same weight to pre-2008 relationships. We are most likely in the midst of a phase shift. The entire global landscape is recalibrating.

Scott Grannis said...

Benjamin: the only evidence to support your assertion that the Fed is too tight is low interest rates. Extremely low interest rates such as we have today could be a sign of very low inflation, but that is not the case today. Inflation is running at a solid 2-2.5%, and is much higher than most Treasury yields. Almost the entire Treasury curve is trading below the inflation rate, which means we have negative real interest rates. Negative real interest rates are a classic sign of monetary policy that is too easy. I would refer you to the evidence of the 1970s, during which time real interest rates were negative, inflation was rising, the dollar was weak, and it is widely accepted that the Fed was too easy.

Low interest rates today can only be a reflection of a market that perceives that economic growth will be extremely weak. The Fed also believes this, which is why they are actively depressing interest rates.

steve said...

the discussion about stocks being so "cheap" is eerily reminiscent of 2008 when I read the same thing in the spring/summer from many so called pundits. the Barron round table was quite bullish in jan of that yr. I see the opposite: a market that is insouciant considering A) a rotten US economy and quite likely softening B) corp profits starting to fall from all time highs C) a fed that is rapidly running out of bullets D) euro reentering recession E) china slowing and SELLING our bonds. sometimes a bear just looks like a bear said...

A different take on the fiscal cliff solution of gridlock...may be the best 'solution', by Jim Paulsen, of Wells Capital Management, dated November 12, 2012.

Fiscal Woes Improving in the Gridlock Era