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As fear declines, prices rise

I've been trotting out this chart off and on for the past two years, and today is an excellent  time to do it again, since the S&P 500 has now made a new post-recession high. The message of this chart is that fear, doubt, and uncertainty have been unusually high since the financial crisis struck in Sep. '08, and that has helped weaken the economy and depress the value of equities. (The Vix index—a measure of the implied volatility of equity options, and shown here inverted—is a good proxy for the amount of fear and uncertainty that is priced into the market. The higher the Vix, the more people are willing to pay for the risk-reducing characteristics of options. You can find a nice discussion of how to understand the Vix here.)

This week has a been a big risk-reducing week, and that's why stocks are hitting new highs.

First we had the elections, in which the electorate sent a very clear message to Washington: stop the spending, and get out of the way of the economy. The Obama agenda is now effectively dead, and the only uncertainty remaining is how much the Republicans can reverse its heavy toll on the economy. How much will Congress be able to roll back projected federal spending? (Yes, you read that right: I believe that cutting federal spending will actually be a boon to the economy, since that is the only way to ensure that future tax burdens do not increase.) Will some or all of ObamaCare be unravelled or even repealed? Will some or all of the additional regulatory burdens inflicted on the economy in the past 18 months be lifted? Will some or all of the Bush tax cuts be extended? Might corporate income taxes be reduced?

Then came the Fed's announcement of QE2. I've been arguing for awhile that QE2 wasn't necessary at all, because there are no signs of deflation (on the contrary, there are plenty of signs of rising inflationary pressures) and there are no signs that the economy is suffering from a lack of liquidity. All the Fed really needed to do was to convince the market that it would do anything and everything to avoid the risk of deflation. Deflation fears have been with us ever since the end of 2008, and the perceived risk of deflation has played a role in keeping markets on edge and new investment and spending on hold. If the Fed could somehow convince the market that deflation risk was off the table, that would unleash a dose of optimism that could in turn result in increased investment and a healthier economy, and that in turn would support higher asset prices.

With all the talk leading up to it, and now with the announcement of QE2, the Fed has successfully reduced the market's fear of deflation. So much so, in fact, that there is now clear evidence in the bond market that inflation fears are rising. The 5-yr, 5-yr forward inflation expectation embedded in TIPS and Treasury prices now stands at just over 3%, the highest level since TIPS were first launched in 1997.

The stock market is rising because the risk of higher future tax burdens has declined, and because the risk of deflation has declined. This translates directly into a higher discounted value of future, after-tax cash flows. It's as simple as that.

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