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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.

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.

M2 update


Reader "unknown" noticed that M2 jumped by almost $50 billion this week, and suggested that might be a sign that money was once again fleeing Eurozone banks for the safety of U.S. banks. However, as this chart shows, the latest jump is merely a reversal of an earlier decline. On average over the past 13 weeks, M2 is growing at a 6.3% annualized pace, which is right in line with its 15-year trend. There was a noticeable "bulge" in M2 which began around the time the Eurozone crisis started heating up last summer, but it hasn't gotten any bigger since mid-August. Meanwhile, a similar bulge in M1 is also reverting to trend growth, and dollar currency is only rising at a 5% annualized pace; big increases in currency growth tend to coincide with global panics in which the dollar becomes the safe haven of choice.

In short, there's not much going on with M2 of late, which suggests that although the Eurozone sovereign debt crisis has been intensifying, it is not resulting in a wholesale run on the Eurozone banking system.

Good morning from Honolulu


We're in Honolulu for a few days, visiting our son and doing some business-related stuff. I snapped this photo (using my new iPhone) about 20 minutes ago from his window looking West—a magnificent rainbow. I thought this would make a nice contrast to the gloom that has once again descended on the markets. It's also a reminder that even as hundreds of billions of debt gets wiped out on the other side of the planet, life still goes on everywhere. The buildings don't disappear, and people keep going to work every day. The U.S. economy is growing. There are all sorts of problems in the world, but chances are good they will get resolved one way or the other without plunging the world into another Dark Age. Billions of free people working in free markets have a remarkable capacity to withstand adversity and overcome seemingly impossible obstacles.

Next week we'll be in Maui for a family reunion, a present to ourselves for having made it through 40 years of married life and having raised four wonderful children. Lots to look forward to, so blogging may be on the light side for awhile.

Housing starts and claims show improvement


October housing starts came in a bit above expectations, but nothing to write home about. Still, this chart, with its semi-log y-axis, shows that the trend in starts is slightly positive, reinforcing my comments yesterday about emerging improvement in the housing market. From a low of just around 500K in early 2009, starts now are up over 25%. The level of starts is still abysmally low, of course, but the critically important change on the margin is positive.


Whereas the best that could be said for most of this year was that weekly claims for unemployment were not rising, it's become clear in recent weeks that claims are now declining. We are now entering the time of year when claims normally begin to rise—next month's claims numbers will really tell the tale, since seasonal factors expect a significant rise in claims. But so far it looks like the rise in claims is less than normal, which in turn means that employers have been running a tight ship (having cut staff to the bone) and underlying economic fundamentals are reasonably solid. Since claims are one of the most real-time of all economic indicators, this is very good news.

The marginal improvement in both these indicators—echoed in many others such as capital goods orders, industrial production, retail sales, and rising levels of employment—is doubly important given that it is all occurring in the shadow of increasingly dismal news coming from Europe. Imagine how excited markets would be if Europe were also improving instead of teetering on the cusp of a financial meltdown.


So this begs the question: as Eurozone swap spreads approach crisis levels, and as U.S. swap spreads get dragged up to levels that show some emerging stress, are U.S. equities crazy over-priced? Not necessarily. I think it would take a very ugly worst-case scenario to unfold in Europe before the U.S. economic and financial fundamentals would take a hit. Our markets are already very concerned, as reflected in the S&P 500's forward earnings PE ratio of 11.7, in 10-yr Treasury yields of 2%, and in 2-yr swap spreads that have reached 53 today. For things to get nasty, we will need to see some serious defaults in the Eurozone, bad enough to wipe out a good portion of the Eurozone banking system, and bad enough to affect commerce and spark the sort of panic that characterized the economic free-fall we saw here in the latter part of 2008. That could all happen, of course, but it requires some heroic assumptions to be confident that we are on the verge of another catastrophic financial and economic collapse that cannot be prevented. At this point, the absence of more bad news from the Eurozone should count as good news for U.S. markets.

Meanwhile, markets have already priced in a default on Greek debt of monster proportions: 75% (i.e., Greek government debt is priced at about 25 cents on the dollar). That would make an eventual Greek default worse even than Argentina's record-setting default of about 10 years ago. Italian debt is now priced to a 20% default, and that is big news considering the Italian government owes more than $2 trillion. Between Greek and Italian debt, the market has already wiped out about $750 billion. This loss has already happened. The PIIGS long ago borrowed lots of money and used it to sustain living standards instead of to improve their economic fundamentals. Their economies did not grow enough to service their debt. The market understands this, and has discounted the debt accordingly. Here's what we don't know: is this discount is deep enough or maybe too deep? Who is going to have to write these losses off on their bottom line, and will that cause enough companies and/or banks to collapse to bring down the world economy?

One important thing to keep in mind is that debt represents an agreement to transfer future cash flows. If debt is wiped out, then the cash doesn't get transferred from the debtor to the creditor; the debtor gets to keep it, and the creditor has less than he expected to have. The underlying economic fundamentals—the roads, bridges, buildings, factories, and workers that generate the cash—are not affected. Wiping out debt does not wipe out production or demand. The losses that will eventually be written down have already happened, because the money the PIIGS borrowed was squandered long ago; they never built the added economic capacity to service the debt that lenders expected them to. Bad luck for lenders, but this isn't the end of the world.

Charts and thoughts

There's nothing particularly noteworthy in the economic news today, so what follows is a quick recap of major releases, with some observations along the way.


October Industrial and Manufacturing Production came in stronger than expected, but the bigger picture is that industrial output is rising at a moderate 4% rate: nothing to get excited about, but nothing to worry about either.




A survey of home builders' sentiment ticked up—surprisingly—this month, and this adds some weight to the case that we have seen the worst in the housing market and may be on the cusp of some improvement. The second chart, showing an index of homebuilders' stocks, also suggests we have seen the worse and are seeing some gradual improvement on the margin. Painfully slow, to be sure, but the trend appears to be heading up. The home vacancy rate also suggests that we have seen the worst and things are improving, although of course there needs to be a whole lot of improvement before we can get back to "normal" conditions. Even though we are still a long way from seeing what might be termed "strength" in the housing market, simply ruling out further weakness is nevertheless quite comforting. As excess housing inventories are worked off and the economy continues to grow and as household formations continue to exceed new construction starts, the case for a rebound in residential construction and a rebound in prices gets stronger.


As was the case with yesterday's PPI release, October consumer price inflation showed some moderation. On a year-over-year basis, there is nothing alarming going on here. However, declining energy prices have played a big role in moderating overall inflation in recent months, and that is almost surely going to reverse in coming months, since crude oil has now broken above $100/bbl. (up almost 35% from the early October low).


This chart compares the yields on 30-yr Treasuries to core inflation. In an ideal world, bond yields would be at least 2 percentage points higher than inflation, and this chart is set up to show that is the case when the two lines are on top of each other. Reality rarely matches the ideal, of course, but the chart is nevertheless helpful in gauging the valuation of bonds on a real return basis. On that score, in the past several decades, bonds have only been less unattractive at the end of 2008 (not to mention several times back in the rising-inflation 1970s). And considering that core inflation has been trending up while bond yields have declined to very low levels, the real-yield-valuation case for owning long Treasuries is very weak. Long bonds are only attractive as an antidote to fear: fear of an implosion in European financial markets that will rock the global economy and deliver us into years of recession or even a global depression. You have to be extremely worried about the future to want to own long Treasuries these days.


This chart compares the year over year growth rate of the consumer and producer price inflation. Both are trending higher, and the PPI seems to be leading the CPI in recent years, suggesting that the rise in the core CPI is likely to continue.


I add this chart to show some long-term perspective on core inflation. Note the extremely low levels of inflation in the early 1960s, when monetary policy was constrained by the gold standard, the dollar was the king of the hill, and the economy enjoyed very strong growth. Note also how this measure of inflation has crept higher since 2002-3, which was when the Fed first started to ease aggressively and the dollar began to decline. I don't think it's a coincidence that growth has been very disappointing in the past four years. With a weak dollar and very low real interest rates, speculative activity becomes more appealing than investing in the real economy. Business investment is rising, but it is lagging woefully behind the growth in corporate profits.

If there is a theme that ties this altogether it is one of growth inhibited by fear and uncertainty. The economy is growing, but only moderately. The value of the dollar is up in the air. The risks of a Eurozone implosion are palpable. Bloated government spending has suffocated economies everywhere, making debt burdens intolerable. Fiscal policies need to change radically, but the political will to do so seems lacking, and crony capitalism is on vulgar display too often. Accommodative monetary policy—which seeks to encourage more borrowing—is not a good solution to a situation made bad by an excess of borrowing, and it only weakens confidence in the future value of currencies. Gold at $1800; wild gyrations in oil prices; high-frequency trading; widening spreads on Italian and French bonds—all are symptomatic of a market that believes that there is more profit to be made in speculation than in new business investment. Speculation is what you get when you weaken the incentives to invest in productive activities for the long haul.

Tax shares update


I've updated this chart to include data recently made available for 2009. The big-picture takeaway hasn't changed: the rich pay a hugely disproportionate share of federal income taxes. The top 1% of income earners paid almost 40% of all federal income taxes; the top 5% paid almost 60%; and the top 10% paid about 70%. The bottom 50% of income earners paid only 2.3% of all federal income taxes, and some 59 million tax filers either paid no income tax or received money on net from the IRS. This puts us perilously close to a "tyranny of the majority" in which there are more people receiving net benefits from the government than there are paying into the system.

One other important thing to note is that the share of total income taxes paid by the top 10% of income earners today has risen by 40% since the early 1980s, despite the fact that the top income tax rate has been cut in half. This is powerful evidence that the Laffer Curve is alive and well: cutting tax rates that are too high can and does yield a lot more in the way of revenue than a static analysis would suggest, because lower tax rates create bigger incentives to work and risk-taking, and they reduce the incentives to shelter, evade, or defer income, thus broadening the tax base. I also note that federal income taxes as a share of GDP were approximately the same in 2009 as they were in the early 1980s, thus proving that lower tax rates do not necessarily translate into reduced tax revenues.

Note: this chart does not include social security taxes, which are much more regressive, thanks to a cap on taxable income. But, given that social security taxes are supposed to be equivalent to a defined contribution plan (i.e., the benefits you receive are proportionate to the what you pay in), this is only fair. What you pay into social security is presumably your money, whereas what you pay in income taxes goes to fund the government.

Apple continues to impress

Two tidbits of news today have likely helped reverse the recent decline in AAPL:

The Android platform is growing increasingly fragmented and subject to virus and spyware attack. Apple's "closed" platform for iPhones and iPads is proving to be superior, despite being widely criticized. Amazon's Fire tablet, launched today, uses an extensively revised and customized version of Android. Those who want to develop new apps for Android devices now must contend with dozens of products, each of which work just a bit differently, and now, with the Fire, have a variety of screen sizes. Already it can be said that the Android platform does not provide customers with a consistent user experience, and at the rate Android malware is proliferating and new Android-based products are launching, this could become a nightmare for both users and developers pretty quickly. Meanwhile, the best that can be said of the best Android-based phones and tablets is that they are almost as good as Apple products. Competition is good, but I don't see how any product out there can overtake Apple's commanding lead, ease of use, quality control, and seamless integration among a variety of devices.

Apple's iTunes Match was launched yesterday and is receiving rave reviews. I'm not a consumer of music, but my son-in-law is, and he reports that last night it took him only an hour and a half to install the latest version of iTunes on his computer, pay $25 to activate iTunes Match, and then let iTunes scan his 6,000 song music library. He now has his entire music collection—including many thousands of tracks that he had scanned from CDs over the years—in Apple's iCloud, available to listen to on his iPad, iPhone, and iMac. Very impressive, and he didn't have to upload any music to do this. iTunes Match even allows you to receive free a higher-quality version of a song you may have scanned long ago at a low bit-rate. It will be tough for others to beat this offering.

Full disclosure: I am long AAPL at the time of this writing.

Retail sales remain strong



October retail sales exceeded expectations (+0.5% vs. +0.3%), and this is one more sign that the economic slowdown which troubled financial markets in late summer is now a thing of the past. Retail sales have advanced 7.2% over the past year and continue to post new highs, despite the fact that there are 6.5 million fewer people working today than there were at the early-2008 high in employment. The U.S. economy has proved far more dynamic and resilient than expectations, and that is an important factor driving equity prices higher even as the world frets over the possible consequences of Eurozone sovereign debt defaults. U.S. economic growth can trump all sorts of ills.

Producer Price inflation moderates


Producer Price Inflation has been elevated for the past year or so, but inflation pressures have moderated in recent months, thanks largely to a decline in energy prices: on an annualized basis, the headline PPI is up only 1.9% in the past three months, while the core PPI is up only 1.1%. This is likely only a temporary respite, but it is nevertheless welcome, since we have enough to worry about these days with all the concerns emanating from the Eurozone.

Once again I'll highlight the fact that for the past several years the core PPI (ex-food and energy) has been rising more or less steadily, despite the huge decline in economic output in 2008 and the presence of an extraordinary amount of economic slack that has been characteristic of the recovery ever since. I believe this is a testament to the power of accommodative monetary policy, and it goes a long way to disproving the Phillips Curve theory of inflation, which has been predicting very low inflation or even deflation due to the large output gap that has persisted since 2008. Both the core and headline levels of the Producer Price Index are substantially higher today than they were in mid-2008 (4.0% and 4.6%, respectively). With monetary policy still very accommodative, it only makes sense to expect that inflation is more likely to rise than fall as time passes.


As this chart of crude oil futures prices shows, the respite from lower energy prices is already a thing of the past. Crude has surged by 30% since its early-October low.


This chart compares crude prices and wholesale gasoline prices (orange line). I think it shows that the decline in crude was probably exaggerated by speculative forces (short covering?) during the summer; crude prices fell much more than gasoline prices, and thus the rebound in crude should probably be discounted to a great extent. Regardless, these two prices will inevitably track each other as time passes, and right now crude seems to be leading the way higher.



We can also thank the ongoing and significant decline in natural gas prices in recent years for helping to keep energy prices relatively subdued. Natural gas is down fully 75% from its 2008 high, while crude oil is down by only 33%. As the second chart above shows, natural gas hasn't been this cheap relative to crude for decades, thanks to significant new drilling techniques which have resulted in a natural gas production bonanza in the U.S. It is hard to underestimate the degree to which cheap and abundant natural gas is going to transform U.S. manufacturing and energy generation in the years to come.

Federal budget update


This chart includes federal revenues and outlays through October, 2011. The budget deficit was $1.26 trillion in the previous 12 months, which is about what it's averaged over the past year. But the big-picture takeaway is shown in the chart above. Federal spending has more than tripled since 1990 (+209%), while nominal GDP rose only 172%. Revenues are lagging, with an increase of only 130%, but that is easily explained by the depth of the recent recession and the very tepid recovery to date. The lion's share of the budget deficit is due to a hugely disproportionate increase in outlays, which, contrary to the Keynesian theories that were used to justify the increased spending, has almost certainly contributed to the economy's current weakness.

If deficit-financed fiscal expenditures could strengthen an economy, ours would be one of the strongest in the world right now. Instead we find ourselves following perilously close, and in the footsteps of, the PIIGS. The solution for all countries burdened by bloated government spending should be obvious but not necessarily painful: simply enforce serious cutbacks in the growth rate of spending. For example, if federal spending were frozen at current levels, and revenues were to increase at only the rate they have posted in the past year (a rate that would be very low compared to the typical growth rate of revenues following recessions), then the federal budget would be balanced in less than 7 years.

Trade facts show contagion risk is small


This is an important chart to keep in mind when thinking about possible contagion effects from abroad (e.g., fallout from an economic collapse of the Eurozone and China). Total U.S. exports account for about 13.4% of GDP, while total imports account for 16.4%.  U.S. foreign trade—both imports and exports—has been expanding more or less steadily and impressively for many decades, but it is still relatively small compared to the size of our economy.

U.S. exports to China account for just under 1% of GDP, and exports to the Eurozone countries account for about 2.4% of GDP. Even if we were to lose all sales to China and the Eurozone effective tomorrow—an almost impossible assumption—that would only represent a loss of about 3% of GDP. And if we include the loss of exports to all Pacific Rim and Eurozone countries—truly unimaginable and essentially apocalyptic—that would represent a loss of only 5.7% of GDP. In a more realistic worst-case scenario, if Eurozone and Pac Rim purchases of U.S. goods and services declined by 20%, this would subtract only 1.1% from U.S. GDP. In short, the U.S. economy is not very vulnerable to foreign disturbances.

To make this point even clearer, a recent study by the San Francisco Federal Reserve demonstrates (rather dramatically, compared to the popular perception that almost everything we buy these days comes from China) that:

Goods and services from China accounted for only 2.7% of U.S. personal consumption expenditures in 2010, of which less than half reflected the actual costs of Chinese imports. The rest went to U.S. businesses and workers transporting, selling, and marketing goods carrying the "Made in China" label. Although the fraction is higher when the imported content of goods made in the United States is considered, Chinese imports still make up only a small share of total U.S. consumer spending.

Once again, the facts show that what goes on in the rest of the world has a relatively small direct impact on the U.S. economy. Even if China were to dramatically revalue its currency—bearing in mind that the yuan has already appreciated 37% vs. the dollar since 1994, and has appreciated 65% in real terms against a currency basket of its trading partners (see chart below)—the adverse impact on U.S. consumers would be modest at best. The reality is that the rest of the world is much more dependent on the health of the U.S. economy than we are on theirs. As the popular refrain reminds us, "when the U.S. economy sneezes, the rest of the world catches a cold."


For those who worry about our "trade gap," the U.S. trade deficit is now only 3% of GDP, which is only marginally higher than the 2% it has averaged since 1970, and only half of what it was at its peak in 2006. But this is still a relatively meaningless figure, since the difference between imports and exports—if negative—represents a capital inflow from abroad: whatever portion of their sales to the U.S. that aren't spent by other countries on U.S. goods and services, must be invested in U.S. bank deposits, real estate, equities, or bonds. If foreign countries suddenly ceased buying anything from us, but we continued on our merry, import-loving way, our exports would certainly suffer significantly, as would our GDP, but we would find a virtual avalanche of foreign capital inundating our financial and property markets.

HT: Brian Wesbury