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Climbing walls of worry: update

There are two ways of looking at the upward progress of equity prices since last summer. For optimists, who see the glass as half full, the market is gradually shedding some of the panic that gripped the world when the risk of Eurozone sovereign debt defaults started to look inevitable. For pessimists, who see the glass as half empty, the market is once again levitating on the fumes of optimism, poised to crash once again as the global economy collapses in the wake of Eurozone defaults (or the second down leg of the US real estate market, or the collapse of the Chinese economy—or all three, take your pick). I'm in the optimists' camp, of course, because as I have been pointing out repeatedly there is plenty of evidence that the market is priced to some dire expectations. Like all true bull markets, this one has been climbing walls of worry for most of the past three years. This is not a market driven by optimism, it's a market that has had to overcome several major bouts of fear and trembling in recent years, and it's still plenty worried about the future.

To begin with, this chart shows how the level of unemployment claims—a proxy for the underlying health of businesses—has been leading the equity market higher. Businesses are firing fewer and fewer people because they have cut costs to the bone, leaving them well-prepared to cope with any future adversity. You can't have a legitimate rally if the fundamentals are not improving.

The Vix index, which measures how much investors are willing to pay to reduce their risk (because it reflects the cost of owning options, which is less risky than owning the assets underlying the options), is a good proxy for the market's level of fear. As the above chart shows, major selloffs in equity prices have typically been driven by increased fear, and rallies by decreased fear.

But even though the Vix has dropped significantly from last summer's peak, it is still elevated from an historical perspective. Plus, 10-yr Treasury yields, which are a good proxy for the market's expectation for long-term economic growth, are still trading at extremely low levels—lower even than at the end of 2008 or during the depths of the Depression. The combination of the two, shown in the chart above, reflects a market that is still somewhat fearful, while having given up almost all hope for a return to decent economic conditions. Call it fearful despair. Moreover, there is still plenty of room for fear and despair to fade away, before we might say that the market has become priced to something resembling optimism.

As the first chart above shows, the PE ratio of U.S. stocks is still at very depressed levels. That PE ratios can be substantially below their long-term average at a time when corporate profits are booming (after-tax corporate profits are now at record levels both nominally and in terms of GDP) can only mean that the market is priced to the expectation that profits will collapse in coming years.

In conclusion, the market is still priced to very pessimistic assumptions about the future. What this means for investors is that lots of very bad and terrible things would have to happen to undermine the current level of valuations. If the world can just avoid another calamity, then risk asset prices can continue to rise.

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