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Tracking the recovery: pessimism still pervasive

For the past three years this blog has been steadfastly of the belief that while the economy was likely to improve, the recovery would be sub-par because of too much fiscal stimulus and too much uncertainty surrounding monetary policy. At the same time, I have repeatedly observed that the market's implied outlook for the economy was overly pessimistic, thus making equities very attractive. And indeed, the economy has been steadily improving, but the recovery has been definitely sub-par. As for the market, I still see signs that it is priced to overly pessimistic assumptions about the future, and therefore still attractive. What follows is a quick recap of some important indicators and how they are evolving:

The ratio of the Vix index to the 10-year Treasury yield is one way of judging how much fear (Vix) is priced into the market, and how much optimism about the future (10-yr) is priced in. Last October this ratio hit a peak as the market braced for a wave of Eurozone defaults, a financial market meltdown, and a double-dip recession. Fear was intense, and the market's outlook for future growth was dreadful. Things have since improved, but there's still a lot of concern expressed in this ratio. The Vix index is still some 40% higher than it would be if the market were calm and relaxed, and the 10-yr yield, at 2%, is still at a level which implies dismal prospects for economic growth. The 10-yr Treasury yield is equivalent to the market's guess for what the Federal funds rate will average over the next 10 years, and it will only average 2% if the Fed keeps the funds rate at or near zero for at least the next several years. And that, in turn, will only happen if the economy remains very sluggish for years to come. If the market believed that today's jobs report marked the beginning of a significantly stronger economy, then it would be pricing in a much more aggressive Fed posture, and that would imply a much higher 10-yr yield.

This chart shows how the ups and downs of fear have been important drivers of equity market performance. On balance, the story of the last three years is simple: the market started out with the expectation that the future was going to be catastrophically bad: years of depression and years of deflation. When the economy started to grow instead of collapsing, the market began to be less fearful, and equity prices rose. We've seen two waves of fear push the market down in the past few years, both caused by concerns over a Eurozone sovereign debt crisis. Yet each time the fears have proved to be overdone, and as fear subsided, equity prices rose.

This chart shows how the relatively steady improvement in the economic fundamentals (i.e., declining weekly jobless claims) has guided the equity market higher. It's hard to argue with improvement in the current fundamentals, even if you remain concerned about the future.

Corporate profits according to the National Income and Product Accounts have never been stronger, yet PE ratios remain very depressed by historical standards, and hugely depressed considering the very low level of Treasury yields (the 7.3% earnings yield of the S&P 500 compared to the 2% yield on 10-yr Treasuries implies a huge equity risk premium). This points to only one conclusion: the market is convinced that profits are set to collapse, perhaps because of a global recession sparked by a Eurozone disaster, and/or because our enormous and growing federal debt burden will crush the economy via a mega-increase in future tax burdens.

I would argue that the Fed's attempts to flatten the Treasury yield curve (by promising to keep short rates near zero for at least 3 years and by selling short-maturity bonds and buying longer-maturity bonds) have very little impact on 30-yr bond yields, because the Fed owns only a very small portion of outstanding, marketable Treasury debt. 30-yr Treasury yields are determined by the market's outlook for growth and inflation, and they are as low as they are today because the market's outlook for growth is still dismal and inflation expectations are unremarkable. However, as the chart above shows, there is a huge and growing disconnect between the rise in equity prices over the past several months, and the continued low level of bond yields. The equity market is grudgingly accepting the view that the economy is doing better than expected, but the bond market is still in the grips of fear. Domestic and foreign investors are still very worried about Eurozone defaults and a financial meltdown, and so the demand for the safety of Treasury bonds is still intense.

The bond market has experienced a rather significant change of late, however, and it shows up in the spread between 10- and 30-yr Treasury yields (the blue line in the above chart). Fed expectations haven't changed much, and that is reflected in 10-yr yields that are still below 2%. But Fed expectations can't keep 30-yr yields from rising as the economy beats dismal expectations. Since early October, 10-yr yields are up 20 bps, whereas 30-yr yields are up over 40 bps. Over the same period, forward-looking inflation expectations have risen from 2.0% to 2.5%, as the market figures that the risk of very low or negative inflation has declined because the economy has proved stronger/less weak than expected.

The market can't be considered to be optimistic about the future until we see that expectations for Fed policy have been radically revised, and that change, if and when it occurs, will show up in a dramatically higher 10-yr Treasury yield. As long as the 10-yr bounces along around 2% (see chart above), we know that the market's outlook for the future remains pessimistic.

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