Selasa, 19 Februari 2013

Having vanquished fear, the market is now ready for optimism

Back in November 2008 I first highlighted the link between the market's fears (using the Vix Index of implied equity index option volatility as a proxy) and the level of the S&P 500, and I've been updating the chart below regularly ever since. It now appears that fear no longer plays an important depressing role in equity prices. 

The Vix soared in the latter half of 2008, and that presaged the market's coming collapse. Then as fear slowly faded, in fits and starts, over the past four years, the equity gradually recovered, climbing "walls of worry" all along the way. Now the Vix is almost back to the "normal" levels that prevailed in early 2007, and the S&P 500 is only 3% shy of the high it registered in October 2007. After 5 agonizing years, we've come almost full circle.

Does this mean the market is now optimistic? No. I think it means simply that the market is no longer afraid of the future; uncertainty spawns fear, but uncertainty and fear have now declined significantly. Equity prices have risen as fear has subsided; the future has turned out not to be as bad as the market had feared. Now it could be said that while the market no longer fears the future, the market nevertheless is not very optimistic about the future. Fear has been replaced by a confident lack of optimism. The market is in a sense comfortable with the idea that the future is not going to be very bright, and indeed could prove to be rather dull and even quite disappointing. 

I suspect that, having moved from being obsessed by fear to now being rather confident that nothing much will happen in the future, the market is ready to enter what is likely to prove a period of slowly rising optimism. With nothing left to fear, the market will be forced to focus on the facts. If the economy proves to do better than the market's dismal expectations, then the prices of risk assets can only rise. As I said in a post last month, "avoiding a recession is all that matters."

If I'm right, and the economy does avoid a recession, this has enormous implications for financial markets and for the economy.

Applying my thesis that fear of the future has been replaced by confidence that the future will be disappointing, here's how I read the market tea leaves today. The yield on cash is essentially zero, 10-yr Treasury yields are a mere 2%, 5-yr TIPS real yields are a miserable -1.6%, and the S&P 500 has a PE of only 15 (equivalent to an earnings yield of 6.6%). That all ties together if you assume the market (in its true collective sense) is confident that the U.S. economy won't be growing much in the years to come. Investors are comfortable owning TIPS and Treasuries at these levels because they don't believe that corporate profits will rise in coming years; indeed, the market is priced to the expectation, I believe, that profits will fall. Why own TIPS with a negative real yield—which guarantees a loss of purchasing power—unless you think alternative investments will deliver disappointing/negative returns? Why keep tons of money in cash (there is almost $7 trillion in bank savings deposits) unless you think that other assets that currently offer much higher yields will decline in price?

I suspect that, as long as the economy avoids a recession, and non-cash and non-Treasury investments continue to underperform the returns on risk assets, people increasingly will review their current asset allocation and conclude that they are being too conservative. They are passing up much higher-yielding alternatives because their assumptions about the future have been proven too pessimistic. People then will attempt to move money out of cash and into just about anything but cash: into real estate, corporate bonds, stocks, and commodities. I doubt that gold will be a major beneficiary of this, however, since in my view gold is still priced to something like a calamity occurring (e.g., hyperinflation, global economic collapse). If we instead just experience slow growth then gold will probably decline. The attempt to move out of cash and into riskier assets will cause the price of riskier assets to rise, and their yields to decline. Eventually, the Fed will be forced to raise the yield on cash until market expectations come back into some sort of equilibrium.

Some might call this a "market melt-up" scenario. Whereas waves of fear and panic drove equity prices to unbelievable lows in early 2009, the return of optimism could spark reflexive equity purchases that eventually drive prices to unsustainable highs.

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