Tuesday , 8 October 2024

These 5 Things Could Prevent Economy from Slumping & Allow Equities to Continue Climbing

This article examines 5 fairly exciting things going on which, at the very least, could economy-2h-8keep the U.S. economy from slumping, and enable equities to continue to climb.

The above introductory comments are edited excerpts from an article by Scott Grannis (scottgrannis.blogspot.ca) entitled Stocks climb walls of worry.

Grannis goes on to say in further edited excerpts:

There are so many things to worry about!

  • Profits might be mean reverting, which could mean a big fall lies ahead;
  • geopolitical tensions are historically high;
  • the U.S. economy is still mired in the weakest recovery in history;
  • President Obama’s approval ratings are at an all-time low;
  • Obamacare has thrown the healthcare and jobs market for a loop;
  • Dodd-Frank is crippling the financial industry;
  • Europe is flirting with its third recession in the past 7 years;
  • Japan is still struggling despite massive monetary stimulus;
  • emerging markets are being punished by a stronger dollar and declining commodity prices;
  • the Chinese economic juggernaut is running out of steam;
  • QE3 is almost finished, and the Fed’s next move is almost certainly going to entail higher interest rates
  • the bull market in equities has been underway for 5½ years, during which time the total return of the S&P 500 index has been an astounding 222%, for an annualized return of just over 23%…[compared with the total return on equities over the long haul of around 8% per year.
[However, in spite of the above:]
  • corporate profits are at record highs, in nominal and real terms, and in relation to GDP,
  • the classic precursors of recession (e.g., tight money, high real interest rates, and a flat or inverted yield curve) are so far completely absent,
  • the PE ratio of the S&P 500 is 17.6, which is only slightly above its long-term average of 16.

The rally could continue; it’s arguably nowhere near bubble territory.

The Correlation Between the S&P 500 Index & the Ratio of the Vix Index to the 10-yr Treasury Yield

The chart below compares the S&P 500 index to the ratio of the Vix index to the 10-yr Treasury yield:

  • The Vix index, by itself, is an excellent proxy for the market’s level of fear and uncertainty (a rising Vix index means that options on equities are becoming more expensive, which in turn means the market is willing to pay more for options since owning options reduces ones’ exposure to risk).
  • The 10-yr Treasury yield has been an excellent barometer of the market’s confidence in the strength of the U.S. economy (Treasury yields fall as investors are willing to accept a lower yield in exchange for their safety, thus making them a refuge in times of weak or negative economic growth).

worry1

The ratio:

  • rises as fear rises and confidence in the economy declines, and it
  • falls as fear declines and confidence in the economy rises.

While it is not surprising, at all, that for most of this year, the correlation between the S&P 500 index and the ratio of the Vix index to the 10-yr Treasury yield has been almost perfectly negative: -0.85, what is of interest, however, is the number of times a significant rise in the Vix/10-yr ratio has coincided with a meaningful decline in equity prices (at least 7 times in less that 2 years, by my count).

Yet each flare-up of worry has subsided, as the fears that worried investors failed to materialize and the U.S. economy kept on growing at a 2-2 ½% pace. In the absence of an actual recession, it’s tough to keep the equity market down, especially since the alternative to being exposed to equity risk means giving up tons of yield (and in the case of going to cash, it means giving up yield entirely). The earnings yield on the S&P 500 is currently 5.7% (the inverse of the PE ratio) while the yield on nominally risk-free 5-yr Treasuries is a only 1.6% and the real yield on risk-free 5-yr TIPS is zero.

Despite the long list of worries, there is still no sign that the U.S. economy is about to roll over.

  • Trillion dollar shots of stimulus and Quantitative Easing failed to stimulate growth,
  • a massive contraction of the federal budget deficit failed to kill growth.
  • The U.S. economy so far has managed to almost completely ignore:
    • the weakness of the Eurozone economy and
    • the big slowdown in Chinese economic growth.

The U.S. economy is massive in size and over the years has proven to withstand all manner of difficulties (e.g., recall that 9/11 came very near the end of the 2001 recession).

In fact, there are some fairly exciting things going on which, at the very least, could keep the U.S. economy from slumping, as follows:

1. Job Openings

As the chart below shows the BLS’ measure of job openings has jumped by almost 24% year to date, and now surpasses the peak in job openings prior to the last recession. This suggests the outlook for the economy is brighter since businesses are more confident in the future.

worry2

2. U.S. Crude Oil Production

Thanks to new fracking technologies, U.S. crude oil production has surged by a phenomenal 60% in just the past three years (it’s up almost 80% in the past 5 years), making the U.S. the largest producer of crude oil in the world…Meanwhile, all that new crude has created tens of thousands of new jobs and, as a welcome side-effect, has given us abundant supplies of very cheap natural gas, which in turn gives U.S. energy-intensive industries a huge leg up on their overseas competitors.

worry3

3. Bank Lending to Small- & Medium-sized Businesses

Since mid-January, just after the Fed announced the tapering and eventual demise of QE3, bank lending to small and medium-sized businesses (see chart below) has expanded at a 13.6% annualized pace. This reflects growing confidence on the part of banks and businesses. The tapering of QE (which is almost over) has not resulted in any reduction in the availability of credit. On the contrary.

worry4

4. Monetary Policy

As the chart below shows, every recession in the past 60+ years has been preceded by a significant tightening of monetary policy. Tight money shows up in high and rising real short-term interest rates (the blue line) and a flat to inverted yield curve (the red line). Today these two variables tell us that monetary policy is still very accommodative, and as such poses no threat to growth. It would take an awful lot of tightening to change that picture, and that is not likely to happen for at least the next 1-2 years.

worry5

5. Mid-term Election Results

Then there is the prospect—increasingly likely—that the Republicans take over control of the Senate after next month’s elections. At the very least this could be the high-water mark for Big Government. In the years to come we could see regulatory burdens declining instead of increasing; marginal tax rates could ease instead of becoming ever-more burdensome; corporate tax burdens could decline, allowing U.S. corporations to better compete in the world and attracting rather than repelling capital.

Conclusion

As long as the U.S. economy avoids recession, equities are likely to continue to climb recurring walls of worry.

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*http://scottgrannis.blogspot.ca/2014/10/stocks-climb-walls-of-worry.html

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