Economic Outlook (Part 5) -- Market Fundamentals

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here. Part 4 (economic fundamentals) can be found here.

Swap spreads are an excellent proxy for systemic risk (the lower the spread the lower the risk), and they have also tended to be good leading indicators of the direction of other markets. In this chart they suggest that the yield on high-yield bonds is likely to remain relatively stable or perhaps decline a bit further. 

Treasury yields are primarily determined by inflation, but the economy's growth potential can also be an important factor (as was the case in late 2008 when 10-yr yields plunged due to widespread fears of an economic collapse). In this chart, the bond market appears to be saying that we have seen the low in inflation, and that both inflation and real growth are picking up. 

Credit spreads still reflect a degree of caution, suggesting that the market is not overly optimistic. Spreads in general are still significantly higher than what we might expect to see if the economy were healthy and financial conditions were normal. 

The Vix index is a good proxy for the market's fear, uncertainty and doubt. Fears have played a major role in the financial crisis, and this chart suggests we haven't yet returned to normal. That, in turn, suggests that there is still substantial upside potential left in the equity market. 


Key measures of market fundamentals show that while there has been substantial improvement over the past two years, we are still short of returning to what might be termed "normal" conditions. This suggests that the prices of risky assets are not overvalued and that the market is not overly optimistic. 

Economic Outlook (Part 4) -- Economic Fundamentals

Part 1 (overview) of this 7-part series, which is taken from a recent presentation I made at UCLA, can be found here. Part 2 (monetary policy) can be found here. Part 3 (fiscal policy) can be found here.

I included this same chart in an earlier post today, but it is worth repeating. The manufacturing sector is doing very well these days, and judging from past correlations, strength in the ISM indices is pointing to 4-5% growth in the overall economy. This is in line with my expectations of 4-5% growth this year.

Corporate profits are very strong relative to GDP. I note that the S&P 500 today is at a level that was first reached in Mar. 1999. Since then, corporate profits have doubled. Another notable fact about profits is that they have far outstripped corporate investment (proxied by capital goods orders in the next chart). Corporations are now sitting on a mountain of cash worth more than $1 trillion. As confidence in the future returns, that means there is the potential for a huge new wave of investment and growth.

Business investment is up 15% over the past year. This reflects increased confidence on the part of businesses, and promises stronger growth in the future by increasing worker productivity.

This model of the valuation of stock prices, which is derived from one developed by Art Laffer in the early 1980s, and is similar to the "Fed model" of equity valuation, suggests that equities would be fairly priced today if one were to use a 6% 10-yr Treasury yield and assume that corporate profits are going to decline to 6% of GDP. In other words, the model is saying that the market is priced to some very pessimistic assumptions, and therefore could withstand lots of bad news.


The manufacturing sector is enjoying robust growth, corporate America is fabulously profitable, and there is a mountain of profits waiting to be reinvested, yet the equity market seems very reluctant to accept that this is a genuine recovery.

ISM manufacturing report very strong

The January ISM manufacturing survey indices came in much stronger than expected. This is  almost what one could call a blowout report, since it leaves no doubt that conditions in the manufacturing sector are improving significantly. As the top chart suggests, the overall index is consistent with GDP growth of at least 4-5%, which is what I'm expecting to see as the year unfolds.

The employment index hasn't been this strong since early 1973.

The export orders index has been volatile in the past year, but January was very strong and there is no indication of any deterioration. The New Orders index was also very strong, rising back to levels not seen since the economy surged in the second half of 2003. The Prices Paid Index was also strong, as 81.5% of the respondents reported paying higher prices. This very strongly suggests that deflation is a thing of the past, and it should be ringing alarm bells at the Fed. Nothing about this report fits the Fed's narrative of an economy that desperately needs massive monetary stimulus with no need to worry about any inflationary consequences.