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Financial conditions are actually quite normal




This chart adds to my comments yesterday about reading the market tea leaves. The chart is Bloomberg's calculation of "financial conditions" and it uses the Vix index and swap spreads—two of my favorites—as key ingredients. What it is saying now is that financial conditions are very close to "normal." That's remarkable, given the raging concerns across the pond over the possible default of major countries and the possible collapse of one of the world's major currencies.


This next chart compares the Bloomberg Financial Conditions Index (white line) to the S&P 500 index (orange line). Note that the two move almost in lockstep, with a correlation of 0.94. What that tells me is that even though the economy is muddling along at a 2% growth rate, as long as financial conditions don't deteriorate, there is upward pressure on the prices of risk assets. We see the same relationship between the Vix and the S&P.

Tranquil conditions at the very least serve to nudge investors in the direction of yield, which in the case of the S&P 500 is substantial: the earnings yield on the S&P 500 is currently over 7%, and earnings have grown 11% over the past year. The world simply can't pass up positive yields if conditions don't deteriorate. Which is another way of saying that the market is priced to some very pessimistic assumptions; if those assumptions aren't confirmed by reality, then risk asset prices are likely to rise.


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