Things are bad, but not as bad as expected

The Eurozone is still in terrible shape, but Eurozone equity prices are up 27% from their June 1st lows. Eurozone equities, in fact, have risen more than twice as much as the S&P 500 over this same period. Are markets turning irrationally exuberant? Not by a long shot.

As I argued in my previous post, with all the bad news and pessimism that's out there, it doesn't make sense to think that markets are even slightly optimistic at current levels. What's happening is that valuations have been so deeply depressed that the market is essentially priced to the expectation of another deep recession—but a recession keeps failing to show up. So even modest growth of 2% or so with continued high unemployment ends up being better than the market expected, and that forces the price of risk assets higher.

Here's a recap of the evidence of pessimistic market sentiment:

Sovereign yields in all developed economies are at extremely low levels. Plus, they are converging with the extremely low yields that have marked Japan's long economic slump. In a sense, the market is saying that the Eurozone and the U.S. economies are destined to suffer the same fate as Japan: prolonged, very weak growth.

Real yields on inflation-indexed bonds are negative. Negative real yields are a strong sign that markets expect very weak growth in the years to come. As the chart above suggests, negative real yields on TIPS are pointing to years of zero growth in the U.S.

PE ratios are below average, even though corporate profits are at record-high levels. This can only mean that the market believes that profits cannot maintain current levels and are almost sure to decline significantly in the years to come.

Earnings yields on equities are substantially higher than corporate bond yields. It's rare for the market to allow earnings yields that are substantially higher than the yield on corporate bonds. Investors are apparently willing to sacrifice a significant amount of earnings yields on stocks in exchange for a much lower yield on corporate bonds, since bonds are senior in the capital structure and thus more secure. In normal environments, equity investors are willing to accept lower earnings yields because they expect future capital gains to more than make up for those low yields. It's also a strong sign of pessimism that investors have stashed $6.6 trillion in bank savings deposits paying almost nothing, when stocks are earning 7%. That huge gap is a good measure of the market's extreme risk aversion today.

Stocks are edging higher because the market is becoming slightly less pessimistic.