E-piphany

The bond market was remarkably calm today, and stocks traded at a fraction of the volumes we saw last week,  with only a 12-point or so range on the S&P cash index until the end of the day (SPX ended -1.3%). The VIX dropped back into the high-30s after spending part of Friday in the high-40s.

Say what you will about the level of the stock market, but I will make two observations. First, if the market was ‘oversold’ on Thursday on a short-term basis, it surely is no longer so after a rally day on Friday and a lethargic mostly-sideways trade today. Second, all of the folks who seemed on Friday to be eager to “buy into the panic” may be a bit early…we are not so removed from the panic of 2008 that we have forgotten, have we? “Panics” don’t end in a week, and they don’t cover 4%.

If there is anything that better exemplifies the way the investing public has been brainwashed by the equity cult, I can’t think of it at the moment. A 4% decline in a week is “a panic” and a buying opportunity.

It has taken decades to get here from the days when dividend yields were expected to be higher than bond yields since the equity stakeholder had a junior interest. Of course, the love affair with claims on residual value (that is, equity) isn’t quite as bad as it was in the late 1990s, but I guess that’s partly the point. A decade later, with broad equity indices 30% lower in nominal terms from the 2000 highs and around 44% in real terms (see Chart), investors still see 4.2% over one week as a panic!

Real S&P (simply SPX/ NSA CPI here)

Folks, there is talk among serious people with considerable public policy chops about whether the Euro might be headed for a breakup at some point; whether this may happen next month or next year or next decade, the very fact that this is a plausible notion is a big deal. Taxes are due to be cranked up in the U.S. over the next few years (both income taxes as well as other taxes such as the substantial ones attached to the health care bill), and government spending in the Eurozone is surely going to be declining with half of the EU implementing austerity measures. Bank lending has been contracting for well over a year, but Congress is responding by gutting the same industry they bailed out. Policymakers need the money to continue to fund the GSEs, as mortgage delinquencies and defaults continue to rise.  Some panic might not be terribly misplaced.

Now, the economic data isn’t bad, but hardly gangbusters. Employment growth (admittedly, usually a lagging indicator) is tepid. The home sales numbers have been improving (today, Existing Home Sales was 5.77mm versus 5.65mm expected and 5.36mm last month), but it is off a very low base and may be related to expiring tax incentives…the jury is still out, in other words. Tomorrow we will get the Richmond Fed Index (Consensus: 25 vs 30 a month ago), Consumer Confidence (Consensus: 58.9 vs 57.9), and the Case-Shiller index (Consensus: -0.3% m/m, +2.5% y/y compared with +0.6% y/y last). Consumer Confidence is a potential weak link, since the unpopular health care bill (63% want the bill repealed) and the Euro crisis have been in the news for a month, but Confidence in the medium-term is driven by jobs. If conditions are truly improving, then “Jobs Hard To Get” should start to fall with more alacrity and Consumer Confidence ought to rise further.

While we are a long way from anything that looks like panic, that isn’t the same as saying that the market is healthy and behaving normally. Indeed, markets continue to look and act more than a little nervous. The behavior of the front end of the TIPS curve, where the Jan-11 maturity whistled from a yield of -1.22% on May 3rd to +0.30% today … that is, a 152 basis-point rise in yields, albeit small basis points … is one example of particular interest to me given that it is a market of focus for me. The Jan-11s only about six months of inflation accretion remaining, so this wild swing amounts to a huge change in near-term inflation expectations. That yield on May 3rd represented market expectations for a terminal NSA CPI value of 219.22, or something like 1.5% annualized inflation over the period from Feb ’10 to October/November ’10. The current yield implies a terminal index of 217.85, meaning almost no change in prices from now until October/November. (Put another way: at an 0.3% real yield, and 9-month nominal paper yielding around 0.3%, any net inflation at all means you’re better off owning that instrument). While declining energy quotes offer the possibility of net deflation over that period, it still seems a little unlikely to me.

More technically, Fed funds/LIBOR swaps continue to trend wider even though Friday and Monday saw some general calming in the market. The jump in 1-year Fed Funds/LIBOR, which roughly indicates the cost of 3-month unsecured money compared to collateralized Fed Funds from 14 basis points (daily average Fed Funds+14bps versus 3mo LIBOR flat, paid quarterly)  in late April to 59bps now is a big move, but more impressive to me are the movements in longer-dated FF/L swaps. Shown below is the 5y FF/L swap (Source: Bloomberg). Compare the rapidity of the recent move to the larger, but slower rise in 2007-08.

Maybe there's some panic, but it isn't retail

So perhaps there are some panicky undercurrents, and conceivably this could be a prelude to actual panic. But it isn’t the retail investor who is panicking yet. We can bottom without a panic, of course, and it would be nice if we do so, but suggesting that everyone else is losing their heads to make ourselves feel good about being Cool Hand Luke – it doesn’t appear to really be happening yet.

I am not entirely sure what it will look like, but I suspect we’ll know it when we see it.