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No shortage of money

Bank lending to small and medium-sized businesses continues to expand, up 10.5% in the year ending Feb. 13th. This is a good sign that the economy continues to grow.


This measure of bank lending to businesses has been rising at double-digit rates for over two years. With banks absolutely flush with reserves, the only constraint on bank lending is a) willingness to lend and b) willingness to borrow. The fact that lending has been rising steadily for over two years is good evidence that banks are more willing to lend and businesses are more willing to borrow. Both suggest rising confidence, and that is the force that is underlying the slow but steady expansion of the economy. Not the Fed's QE, and not government spending. The growth we are seeing is the result of the private sector healing, not the public sector stimulating, despite what you may read in the papers. The Fed is facilitating the increased lending, by supplying ample amounts of reserves, but not driving it.

Truck tonnage shows economy continues to grow

Truck tonnage in January was up 6.5% from a year ago, strong evidence that the economy continues to expand. 


I like this chart because it shows a decent connection between increasing truck tonnage (a good proxy for the size of the economy) and the S&P 500. This is by far from perfect, but it does help flesh out my thesis that the stock market is rising because the economy is growing, however slowly. When trucks are moving more stuff around, it's highly likely that economic activity is expanding.

Climbing little walls of worry

I hadn't been watching things very closely the last few days, and so I was shaken to see the market drop amid concerns that the Fed was likely to end its current Quantitative Easing program. But after looking at market fundamentals, I'm reassured that this is nothing more than a "little wall of worry" in the market's long climb to new highs.

If the Fed were going to accelerated its tightening timetable, then that should be reflected in a significant rise in 2-yr Treasury yields. The yield on 2-yr Treasuries is driven primarily by the market's guess as to what overnight rates will average for the next 2 years. Yet those yields have not budged on average for the past six months, and in the past few days they have even dropped a few basis points. Swap spreads are still very low and have not budged at all. So the bond market is not worried at all about a tighter Fed. The only sign of concern is the Vix index, which has jumped from 12 to 15, but that's not telling us anything about the economy, only about how worried investors are.

And even if the Fed were to begin raising rates sooner than expected, that is hardly a reason to worry. It's more logical to think that would be a good thing, since the Fed's current ultra-accommodative policy stance has created mountains of uncertainty about the future value of the dollar and inflation. Short term rates of 1, 2, or even 3% wouldn't pose a problem at all to the economy if it were a bit stronger than it is today, and there is almost no chance the Fed would raise rates if the economy were truly headed for a fall.

In the meantime, all the Fed is doing with its QE program is to swap bank reserves for bonds. It's not printing money, and it's not directly sustaining the equity market. Banks already have way more than enough reserves to support massive increases in lending. Financial market liquidity wouldn't begin to be adversely impacted until the Fed started aggressively draining reserves, and that won't happen for a long time.

What is sustaining the equity market is the realization that the economy is not doing as badly as had been expected. It's still growing, albeit slowly. The yields on non-Treasury securities are very attractive as long as the economy doesn't sink into another recession, and there is no sign of that about to happen.

Blogging will be light this week

We're going skiing with the family, in what I hope becomes an annual tradition. And in the meantime, if the sequester hits, I won't be worried at all. It's only a very small portion of total government spending, which is already way too big. A little austerity on the spending side is overdue: way past time for the federal government to tighten its belt. The rest of the country has been doing that for years now.

Housing starts still looking strong

January housing starts were below expectations, but this is a volatile series and seasonal factors can easily distort the month-to-month data around this time of the year. Starts remain in a strong uptrend, and that is confirmed by the ongoing rise in building permits. Separately, the Architecture Billings Index for January was very strong. Taken together, it is clear that construction of homes and commercial space is in full recovery mode.


Even with the January decline, starts are up 65% from the end of 2010. Historically, starts are still very weak, but the recovery from the abysmal recession lows has been very impressive. Lots of room left on the upside.


Building permits are less volatile than starts. They are up 65% from Nov. 2010, and they rose a very strong 35% in the year ended January.


The Architecture Billings Index as hit a new post-recession high. The recovery here has taken a long time to get underway but it now looks like it is on solid ground.

Having vanquished fear, the market is now ready for optimism

Back in November 2008 I first highlighted the link between the market's fears (using the Vix Index of implied equity index option volatility as a proxy) and the level of the S&P 500, and I've been updating the chart below regularly ever since. It now appears that fear no longer plays an important depressing role in equity prices. 


The Vix soared in the latter half of 2008, and that presaged the market's coming collapse. Then as fear slowly faded, in fits and starts, over the past four years, the equity gradually recovered, climbing "walls of worry" all along the way. Now the Vix is almost back to the "normal" levels that prevailed in early 2007, and the S&P 500 is only 3% shy of the high it registered in October 2007. After 5 agonizing years, we've come almost full circle.

Does this mean the market is now optimistic? No. I think it means simply that the market is no longer afraid of the future; uncertainty spawns fear, but uncertainty and fear have now declined significantly. Equity prices have risen as fear has subsided; the future has turned out not to be as bad as the market had feared. Now it could be said that while the market no longer fears the future, the market nevertheless is not very optimistic about the future. Fear has been replaced by a confident lack of optimism. The market is in a sense comfortable with the idea that the future is not going to be very bright, and indeed could prove to be rather dull and even quite disappointing. 

I suspect that, having moved from being obsessed by fear to now being rather confident that nothing much will happen in the future, the market is ready to enter what is likely to prove a period of slowly rising optimism. With nothing left to fear, the market will be forced to focus on the facts. If the economy proves to do better than the market's dismal expectations, then the prices of risk assets can only rise. As I said in a post last month, "avoiding a recession is all that matters."

If I'm right, and the economy does avoid a recession, this has enormous implications for financial markets and for the economy.

Applying my thesis that fear of the future has been replaced by confidence that the future will be disappointing, here's how I read the market tea leaves today. The yield on cash is essentially zero, 10-yr Treasury yields are a mere 2%, 5-yr TIPS real yields are a miserable -1.6%, and the S&P 500 has a PE of only 15 (equivalent to an earnings yield of 6.6%). That all ties together if you assume the market (in its true collective sense) is confident that the U.S. economy won't be growing much in the years to come. Investors are comfortable owning TIPS and Treasuries at these levels because they don't believe that corporate profits will rise in coming years; indeed, the market is priced to the expectation, I believe, that profits will fall. Why own TIPS with a negative real yield—which guarantees a loss of purchasing power—unless you think alternative investments will deliver disappointing/negative returns? Why keep tons of money in cash (there is almost $7 trillion in bank savings deposits) unless you think that other assets that currently offer much higher yields will decline in price?

I suspect that, as long as the economy avoids a recession, and non-cash and non-Treasury investments continue to underperform the returns on risk assets, people increasingly will review their current asset allocation and conclude that they are being too conservative. They are passing up much higher-yielding alternatives because their assumptions about the future have been proven too pessimistic. People then will attempt to move money out of cash and into just about anything but cash: into real estate, corporate bonds, stocks, and commodities. I doubt that gold will be a major beneficiary of this, however, since in my view gold is still priced to something like a calamity occurring (e.g., hyperinflation, global economic collapse). If we instead just experience slow growth then gold will probably decline. The attempt to move out of cash and into riskier assets will cause the price of riskier assets to rise, and their yields to decline. Eventually, the Fed will be forced to raise the yield on cash until market expectations come back into some sort of equilibrium.

Some might call this a "market melt-up" scenario. Whereas waves of fear and panic drove equity prices to unbelievable lows in early 2009, the return of optimism could spark reflexive equity purchases that eventually drive prices to unsustainable highs.