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Panic exhaustion revisited





Comparing the level of the Vix Index of implied equity volatility to the level of the 10-yr Treasury yield is a handy way of gauging how extreme market sentiment is. The Vix index is a good proxy for fear (because the implied volatility of options determines how expensive it is to purchase options in order to limit one's downside risk), and the 10-yr Treasury yield is a good proxy for the market's long-term outlook for growth and inflation. When you combine a high level of the Vix with a low level of the 10-yr, you have a market that is not only very fearful but also very pessimistic about the future. The top chart shows the ratio over the past two decades, while the bottom chart zeros in on the ratio over the past 4 years. Bottom line, we are living in times of great fear and pessimism.

I wrote back in July ("Carmageddon, free markets and the PIIGS crisis") about how fear, knowledge and time can short-circuit prophesied disasters, and I suggested that the PIIGS crisis might therefore end with a whimper instead of a bang. I still think that is possible, and the more time that passes, the greater the likelihood that of even a multiple PIIGS default will prove to be much less awful than the market currently fears. After all, the world has had almost a year and a half to adjust to the risk that the PIIGS countries were in trouble and might default. That's a lot of time, and any sentient investor or risk manager with serious exposure to a PIIGS default most likely has taken steps to reduce his exposure. When risk is hedged it is diversified, so PIIGS default risk has likely been spread out over much of the world; and of course the ECB and Germany have in the meantime been willing to shoulder a good deal of that risk.

To judge by the Vix/10-yr ratio, markets and investors have only been so consumed by fear, uncertainty, doubt, and pessimism once before—the period starting with the collapse of Lehman in 2008 and ending with the beginning of the current recovery in mid-2008. But back then we did have monster defaults and we saw the decimation of banks and their balance sheets, and we did have a global economic collapse and a financial panic that brought us very close to the feared abyss called "the end of the world as we know it." Today we have been waiting 18 months for this to happen again. I reiterate what I described three weeks ago, in my mid-September post on panic exhaustion: debt defaults don't destroy demand, banks can be recapitalized, government spending cuts actually make the outlook rosier, and most of the damage from too much debt has already happened. "The failure of a bank is simply the last chapter in a book about money being flushed down the toilet. It's not the end of the world."

It's not that the suspense of a PIIGS default is killing us. The longer the suspense lasts, the less likely it is to kill us.

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