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Fear subsides, equity prices rise

Yet again I post an update to this chart, which has captured quite well the underlying theme of the 2008-9 recession. The near-collapse of the global financial industry in late 2008 sent a tsunami of fear throughout the global financial markets and temporarily paralyzed global economies. Activity in many areas ground to a halt as consumers hoarded cash, institutional investors scrambled to sell risky assets, and everyone tried to deleverage. Fear was the common denominator, as captured by the Vix Index (the implied volatility of equity options), and it peaked in late October 2008. Equity prices continued declining, however, as new concerns were added, mainly the risk of a huge increase in future tax burdens caused by an unprecedented expansion of the federal government and a massive "stimulus" bill.

The past two years have been all about the unwinding of fear and the scaling back of the concerns over future tax burdens. Money has been "de-hoarded" to some extent, retail sales have recovered to their previous high, the economy is 18 months into a recovery, jobs are being added, industrial production is expanding, capital spending is rising, and federal revenues are growing at a double-digit pace, the Vix Index is back down to 16, only marginally higher than one might expect it to be during "normal" times, and Congress has a new mandate to sharply curtail spending and avoid new taxes. We haven't made a full recovery yet, but it is clearly visible on the horizon. The S&P 500 is only 18% below its 2007 high, but the CBOE technology index has already surpassed its 2007 high by 13%, and consumer staple stocks are only a few inches below their all-time high.

Two years ago the financial markets were priced to an "end-of-the-world-as-we-know-it" scenario. Today financial markets are beginning to realize that a return to "normalcy" is possible and within reach. We should all breathe a great sigh of relief.

Now, the Fed needs to realize this and plan its QE2 exit strategy ASAP. Otherwise we could find ourselves snatching defeat from the jaws of victory.

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