A moderate case of the jitters

As a follow-on to yesterday's post, here is another way to measure how pessimistic the market is, and how much actual deterioration in the fundamentals there has been. The chart takes the Vix index of implied equity volatility and divides it by the yield on 10-yr Treasuries. The higher the Vix, the higher the degree of market uncertainty and fear; the lower the yield on Treasuries, the weaker the economy is perceived to be. So a higher ratio is bad, and a lower ratio is good.

This ratio has recorded some pretty spectacular spikes over the years, but today's level is only moderately elevated (6.26). This jibes with the other indicators I showed yesterday, with the conclusion being that the market is definitely concerned about the outlook and the fundamentals, but not to any alarming degree. I could say the same thing for Euro 2-yr swap spreads, which at 52 bps are definitely above average, but not by a lot.

In Don Luskin's book "I Am John Galt", the section on Alan Greenspan makes the interesting observation that Greenspan was pursuing a stealth gold standard as Fed Chairman from 1987 through the late 1997. The Fed funds rate fairly closely tracked the price of gold, which is what one would expect to see if indeed the Fed were on a gold standard. During that same period, inflation was fairly low and relatively stable, and there was a noticeable lack of market panics. But after 1997 the Fed started raising the funds rate even as gold and commodities declined. Greenspan apparently switched from his Randian focus on gold and adopted the more popular Phillips Curve vision of inflation. Phillips Curvers were very worried in the late 1990s that the U.S. economy was "overheating" and that too much growth would prove inflationary. The facts proved them and Greenspan wrong, however, since the economy slipped into recession in 2001 (as it usually does when monetary policy becomes too tight) and inflation fell to very low levels. In fact, we came pretty close to experiencing outright deflation in 2002 and 2003. That put the fear of God into Greenspan, since he subsequently decided to pursue an extraordinarily accommodative policy for the next several years, and that contributed to inflate the housing bubble. With monetary policy cut loose from the anchor of gold, is it any wonder that the Vix/10-yr ratio has experienced such extreme volatility in recent years?

Must-read: "I Am John Galt"

I've finished Don Luskin's "I Am John Galt: Today's Heroic Innovators Building the World and the Villanous Parasites Destroying It", and I can now very highly recommend the book to anyone who believes in the power of free markets and individual liberty. But if you haven't read Ayn Rand's Fountainhead or Atlas Shrugged, then by all means read them first.

Luskin gives new life to Ayn Rand's books, logic, and philosophy, by showing how timeless they are. Each of her major characters has a counterpart in today's world, and the major themes are still being played out today:

The Individualist: Steve Jobs as Howard Roark, the man who reinvented four industries just because it was so cool.

The Mad Collectivist: Paul Krugman as Ellsworth Toohey, the man who preaches socialism from the pages of America’s newspaper of record.

The Leader: John Allison as John Galt, the man who walked away after building America’s strongest bank.

The Parasite: Angelo Mozilo as James Taggart, the businessman who co-opted government and nearly wrecked the U.S. economy.

The Persecuted Titan: Bill Gates as Henry Rearden, the businessman who created revolutionary technologies and was criminalized for his success.

The Central Planner: Barney Frank as Wesley Mouch, the politician who meddled in the economy and almost destroyed it.

The Capitalist Champion: T. J. Rodgers as Francisco d’Anconia, the modern Renaissance man, and agent provocateur for capitalism.

The Sellout: Alan Greenspan as Robert Stadler, the libertarian who became an economic czar.

The Economist of Liberty: Milton Friedman as Hugh Akston, the academic who showed the world the connection between capitalism and freedom.

Don has written a lively and engaging tour de force that, if widely read, could help set our politics and our economy back on the track of growth. Don't miss it, and help spread the word.

Putting the ISM news in context

Going into today, we knew that manufacturing activity in May was disrupted in the wake of the Japanese tsunami, terrible weather, and early auto shutdowns, but nevertheless the market is having a problem digesting the news that the May ISM manufacturing indices were weaker than expected. Still, as the chart above shows, even with a significant drop in the main ISM index, there is no reason to expect that GDP growth in the current quarter is going to be any weaker than it was in the first quarter. The current level of the ISM index is consistent with GDP growth of 3-4%.

The employment component of the ISM index also fell sharply, but it is still at historically strong levels, levels that have been seen only a handful of times in the past several decades.

A decline in activity had little impact on the inflation fundamentals, with the prices paid index still registering rather elevated levels of price pressures.

Export orders fell sharply in May, but they are historically volatile and still consistent with growth.

Meanwhile, all major commodity indices have turned up from their May lows, including my favorite (above), the CRB Spot Commodity Index.

The May Challenger tally of announced corporate layoffs remained very low, but the May ADP estimate of new private sector jobs dropped much more than expected. Conclusion: hiring plans were disrupted in May, but there is no sign that employers want to reduce employment levels.

I think the proper conclusion to all this is that while economic activity was indeed disrupted meaningfully in May, there is no reason to think that conditions or fundamentals have permanently deteriorated or are getting worse. Indeed, commodity prices are signaling that things are are already on the mend. Consequently, it is likely that U.S. markets are overreacting to the downside, and we should expect better news in the weeks to come.