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Markets are still priced to a very ugly outcome




This chart recaps the level of systemic risk in the U.S. vs. the Eurozone, using 2-yr swap spreads as the proxy. By this measure, the situation in Europe today is almost as bad as it was during the global financial panic of late 2008. But systemic risk in the U.S., though somewhat elevated, is still relatively low. Investors worry a lot about the possibility of contagion from Eurozone defaults, but in practice no one is demanding an excessively high premium to take on U.S. counterparty risk.


This chart compares the level of swap spreads to the average yield on junk bonds. Since Treasury yields have been extraordinarily low for some time now, the level of yields is arguably a better indicator than spreads for the actual difficulties faced by high-yield-rated companies. Both measures of risk are somewhat elevated, but they are nowhere near as bad as they were in 2008. The problems in the Eurozone are having only a modest impact on conditions here in the U.S., and investors are willing to accept counterparty and low quality credit risk for a relatively low premium.


This chart compares 5-yr swap spreads to spreads on 5-yr A1-rated industrial bonds. Here again we see that the premium necessary to convince investors to accept these risks is still relatively low.



Now contrast the relatively low levels of systemic risk and investor fear that can be found in the bond market to the very high level of fear that can be found in the equity market. The chart above shows the PE ratio of the S&P 500 compared to the 1-yr forward consensus view of earnings. Investors are only willing to pay a multiple of 11.7 times expected earnings, which is equivalent to saying that the expected earnings yield that investors demand in order to hold equity exposure is 8.5%. Investors today are almost as reluctant to hold equity exposure as they were at the end of 2008, when the global economy was in free fall and financial markets were terrified by the fear that the global banking system would collapse. The same analysis holds for Eurozone stocks (second chart above), although PE ratios in general have been much lower for European stocks then they have for U.S. stocks (presumably because the long-term growth outlook for Europe has for a long time been less robust than for the U.S.).


Circling back to the bond market, the level of 10-yr Treasury yields is extremely low, and is consistent with the view that the outlook for the economy is utterly dismal.

I'm not sure I have a good explanation for these disconnects. Spreads in the U.S. are priced to a modest level of concern, while spreads in Europe are priced to an extremely high level of concern. Treasury yields and PE ratios, in contrast, are priced to the gloomiest of outlooks. But however you look at it, there appears to be no shortage of pessimism in today's market pricing. In fact, optimism is very difficult, if not impossible, to find. AAPL, for example, has a forward-looking PE ratio of only 10.9 according to Bloomberg, which means the market is extremely skeptical of analyst's earnings projections. AAPL's current PE of 13.6 is only slightly higher than the S&P 500's 12.8, and this for a company that has grown earnings at a spectacular rate for years.

So I come back to the theme that has been dominant for the past three years: markets are very, if not extremely, pessimistic, and valuations are therefore very attractive if one believes that the U.S. and global economies are not going down the toilet. Even holding only a modestly positive outlook for the future makes one extremely optimistic relative to the outlook embedded in market pricing. By the same logic, being bearish today (i.e., hiding out in cash that pays nothing) is a very expensive proposition, and is likely to pay off only if the U.S. and global economy really get bad.

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