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Random charts and thoughts



Blogging has been light mainly because I haven't run across any new or interesting developments. We are still in a modest/moderate growth environment (about 2% per year) with relatively low inflation (about 1.5-2%). The Fed is gearing up for the end of QE, first by tapering its purchases, and later (late next year?) by raising the interest rate it pays on bank reserves. The market was initially spooked by the prospect of a QE unwinding, but now has put those fears to rest. There are no signs of any deterioration in the economy, and as long as the economy avoids recession, risk assets—which yield substantially more than risk-free cash and cash equivalents—are likely to rise in price.


If weekly unemployment claims are a good proxy for the health of the economy, then the chart above demonstrates that equity prices have risen in line with an improving economy. Lots of wiggles and mini-panics along the way, but the improving trend in both series remains intact.



The current PE of the stock market is very close to its long-term average, even though corporate profits are at near-record levels relative to GDP. Stocks may be fairly valued, but they are not overvalued by these measures.


The earnings yield on the S&P 500 is still above the yield on BAA corporate bonds. This shows that the equity market is still not very confident in the outlook for earnings, since it is willing to forego the appreciation potential of stocks and give up yield at the same time, in exchange for the relative security of bonds, which are senior in the capital structure.



The two biggest changes on the margin in financial markets in recent months have been the decline in gold prices and the rise in real yields (or, if you prefer, the decline in TIPS prices). Both have been tightly correlated for the past 6-7 years (see first chart above). Both TIPS and gold are classic inflation hedges, so their declining prices are symptomatic of declining concern over the outlook for inflation. But as the second chart shows, the recent decline in inflation expectations (the green line) is quite modest when viewed from an historical perspective.


As the chart above suggests, the big rise in real yields/decline in TIPS prices has a lot more to do with the market's outlook for real growth that it does with the market's inflation expectations. The very low level of real yields several months ago was symptomatic of a market that was quite pessimistic about the prospects for growth. Investors were willing to pay very high prices for gold and TIPS because they feared that very weak growth prospects raised the risk of losses in alternative assets. Gold and TIPS are "safe assets" that no longer command such a high premium because investors' fears, uncertainties, and doubts about the future have declined somewhat in recent months. This dovetails as well with recent modest rises in consumer confidence and increased bank lending.


Many worry that declining gold and TIPS prices signal and increasing risk of deflation. But as the chart above shows, it's more likely that gold has declined because it had previously risen by an extraordinary amount, far above the rise in other commodity prices. In the absence of any rise in the inflation rate, gold was going to have a very tough time remaining at such elevated levels. Gold is now in the process of realigning itself with commodity prices. Commodity prices are down from their 2011 peak, but they are still well above (130% above) their 2001 lows. This is all symptomatic of a market that not too long ago had very big concerns about weak growth and rising inflation—concerns that have now been somewhat assuaged. There's nothing here that would suggest deflation.


After a brief, QE-temper-induced uptick, credit spreads have settled back down to their lowest levels since the Great Recession. They are still substantially higher than they were during times of relative tranquility and strong growth (e.g., 1997 and the mid-2000s), but they do not reflect any deterioration in the economy's health, nor any great concerns. The market is now saying that an earlier-than-expected end to QE is not necessarily a bad thing for the economy. The economy will very likely not suffer if the Fed proceeds with a tapering of QE prior to the end of this year.



As the first of the above charts shows, the Vix index of implied equity volatility (a proxy for the market's degree of uncertainty) is relatively low, having declined in fits and starts from extremely high levels during the Great Recession. The market is much less uncertain these days. The second of the above charts shows the ratio of the Vix index to the 10-yr Treasury yield (a proxy for the market's confidence in the health of the economy). Like the Vix index, this ratio has also declined in fits and starts from extremely high levels. You might say that this chart is showing the while the market is less uncertain about what the future holds, it is still not very optimistic about the economy's ability to grow—10-yr yields are only 2.5%, and that is very low from an historical perspective, lower even than during the Depression.

So we are making progress, and the economy continues to grow, albeit at a disappointingly slow pace. Uncertainty is down, pessimism has receded, but enthusiasm is still in relatively short supply.

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