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Thoughts on the rally




The rather spectacular rally in equity prices since Mar. '09 continues. As we close in on the pre-recession highs in the stock market, I think it's important to stress once again that one of the major causes of the economic and financial crash of 2008-09 was fear: fear of deflation, of depression, of a collapse of the global banking system, of massive corporate bankruptcies, of a housing market meltdown, of a future with staggeringly high tax burdens, and of a significant increase in the size and burden of government. Both the Vix index and swap spreads soared in late 2008 as fear mounted.

The rally has been propelled by the diminishing likelihood that these fears will be realized. It has also been driven by Fed policy which keeps short-term interest rates near zero.

When the interest rate on cash and cash-subsititutes is essentially zero, then one can reasonably refrain from purchasing riskier and higher-return assets only if one is convinced that the worst fears of the market are going to be realized. When it turns out instead that the economy improves and the potential for catastrophe recedes on almost a daily basis, equity prices have nowhere to go but up. Moreover, for the past several months the potential for very constructive change in fiscal policy has improved significantly. The first part of the rally was thus driven by a decline in catastrophe risk, and now the second part is being driven by the rebirth of optimism. There are lots of reasons to be optimistic today, yet key prices (e.g., PE ratios, credit spreads, implied volatility, Treasury yields) have yet to reflect any sign of optimism regarding the outlook for growth and prosperity.

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