Senin, 09 Juli 2012

Reading the market tea leaves

What follows is a brief recap of what I think are the key indicators of market sentiment and their implications. Conclusions: markets are priced to very pessimistic growth assumptions; the risk of catastrophic failure has declined meaningfully; financial markets are for the most part liquid and functioning; risk-aversion is still extremely high; deep-seated fear and uncertainty have been replaced by a conviction that there is little hope for any meaningful growth in the global economy for the foreseeable future.

This first chart compares the Vix Index (a proxy for fear and uncertainty) with the S&P 500 (a proxy for the value of the U.S. equity market). Every major selloff in equities in recent years has been driven accompanied by a rise in fear and uncertainty. Fear and uncertainty have now declined to levels that are only modestly elevated, and equities are, not surprisingly, approaching their pre-recession highs.

However, profits as a % of GDP are now very close to their all-time highs, and are more than 40% above their pre-recession highs. The PE ratio of the S&P 500 is more than 20% below its pre-recession level. Therefore, it seems clear that the market is very pessimistic about the prospects for growth and profits in the years to come. 

The Vix index (a good proxy for the market's fear level) is still somewhat elevated, but it is much lower today than its prior peaks. Each episode of rising fear has resulted in an equity market selloff, and each time fear subsides, equity prices have risen. The current episode of declining fear is no exception. Currently, with 2-yr swap spreads firmly in "normal" territory and the Vix index not too far above its "normal" range of 12-15, .......

10-yr Treasury yields are at all-time lows. This not only reflects the market's fear that prospects for U.S. growth are dreadful, but also the global market's extreme risk-aversion.  

10-yr TIPS real yields are at all-time lows. Yet the difference between 10-yr nominal and real yields—the market's expected average inflation rate over the next 10 years—is 2.1%, which is only slightly below its 10-yr average. Despite the extremely weak recovery to date, and the economy's estimated 12% "output gap," inflation expectations have not turned negative. In fact, 5-yr, 5-yr forward inflation expectations embedded in TIPS and Treasury pricing are currently 2.6%; this in turn suggests that the risk of deflation is not a major concern for the market. That follows from the fact that the dollar is very close to all-time lows, the fact that Fed policy is both admittedly and in fact ultra-accommodative. 

Real yields on TIPS are heavily influenced by the economy's recent and expected growth potential. Investors who buy a 5-yr TIP with a real yield of -1% have the alternative of buying the S&P 500 index, so on a risk-adjusted basis (TIPS are default-free, whereas equities are not) they must be relatively indifferent to this choice, which in turn implies that expectations of real returns on equities are very low. If this chart is any guide, the -1% real yield on 5-yr TIPS suggests that the market expects zero real growth in the U.S. economy over the next few years and by inference, very low real returns on equities.

The Vix index is low, suggesting that the market is much less worried about the uncertainties of the future than it was just a few months ago. Since 10-yr yields are also very close to all-time lows, this suggests that the market seems relatively confident that the outlook for U.S. economic growth is dreadful. However, the prospect of very weak growth for the foreseeable future has not led to the catastrophically distressed valuations that we saw following the Lehman collapse and the past two outbreaks of Eurozone fears. Still, the ratio of the Vix to the 10-yr yield remains very high from an historical perspective, suggesting that valuations are still very distressed.

Despite the market's periodic attacks of fear in recent years, the gradual improvement in the economic fundamentals of the U.S. (in the case of this chart, the declining level of weekly unemployment claims) have provided support for the equity market. Eurozone fears are one thing, but so far the U.S. economy has proved to be quite resilient to any Eurozone contagion. As long as the U.S. fundamentals fail to deteriorate, Eurozone fears are likely to prove temporary and fleeting. 

2-yr swap spreads are good proxies for the degree to which banking systems face systemic failure. U.S. spreads today are firmly in "normal" territory, while Eurozone spreads have retreated significantly from last year's highs. 

This last chart compares Euro basis swap spreads (a measure of how difficult it is for Eurozone banks to get dollar funding) with 2-yr Eurozone swap spreads (a measure of systemic risk and the health of the Eurozone banking system). Both have declined this year by a substantial amount, thanks to aggressive efforts by the Fed and the ECB to supply much-needed liquidity to financial markets. Europe is not out of the woods yet, to be sure, but the risk of catastrophic failure has declined significantly. Liquid markets are the private sector's best chance to get things fixed, by distributing risk from those who don't want it to those who do. To judge from this chart, the Eurozone is making important progress. 

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