One may hear talk that investors are "worried," whether due to the election, or Brexit, or some other factor. But can we actually quantify that to see if there are any follow-through ramifications of the effects of uncertainty? The short answer is yes. We can look at asset prices to tell us what investors are thinking, but we get some very different results, depending on which markets we examine. Also, we must tease out the (very large) effects of things like central bank bond buying programs are having on markets.
Take U.S. stocks, for example. According to Dow Jones data, the price to earnings (P/E) ratio of the S&P 500 was 24.59, compared to 21.53 a year ago, which itself was higher than the long term average of about 17. The higher the multiple, the more investors are willing to pay for a dollar's worth of earnings - and the more risk they undertake should earnings not meet their forecasts. In other words, a higher P/E ratio is associated with less worry, not more, at least for U.S. stocks.
Indeed, stock investors currently expect volatility to relatively low. One way we can measure this is in the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX for short. This is derived from the implied volatility embedded in options pricing; the greater this level, the more volatile equity markets might be expected to be. And the lower the level, the less "worried" investors appear - and right now, the VIX is at relatively low levels, comparable to what it had been during parts of the 1990s and 2000s.
But we get a very different signal from U.S. Treasuries. Consider the nearby graph on the yields on the ten year U.S. Treasury note. A low yield on this investment could mean, at times, that investors are willing to accept very little compensation - especially relative to inflation - in order to protect their assets from possible risk. Because inflation can be a big part of how high or low Treasury yields are, this measure strips out inflation, leaving just the "real" yield so we can compare levels across history.
From the long history of these data, it might seem as though the bond market expresses a considerable amount of "worry" - at least at first glance. Importantly, remember that Treasuries are subject to interest rate risk, which may be of some concern at today's low, inflation-adjusted rates. In other words, there is currently no premium to compensate investors for interest rate risk, as investors seem to be apparently focused on protecting their portfolios from other potential risks.
If these conflicting signals aren't enough, go to a different part of the bond market, that of high yield debt, which bears considerable amount of credit risk. Here, we can measure the difference in yields between high yield bonds and safe-haven Treasuries. The smaller the difference, the less "worried" investors might appear to be. And right now, those credit spreads are in the range of where they have been historically, perhaps a little more, but not by much.
Well, are investors worried, or not? As it turns out, these data, while essential ingredients in many an analyst's models, are a bit distorted. Where we need to turn to put this into perspective is the actions by the European Central Bank and the Bank of Japan, which have served to pull down Treasury yields, as we see in the nearby graph. This graph compares the 10 year German bund yield with the 10 year U.S. Treasury, and the measure of forward-looking inflation expectations for the five years beginning five years from now. Note how correlated German bond yields had been to Treasuries up to 2012. And during that period, Treasuries offered an inflation premium. As the ECB ramped up its bond purchase program to drive down yields, falling German rates dragged down Treasury yields as low as investors were willing to go, down to the rate of expected inflation, but no further.
At that point, investors sought other investments, in a so-called TINA strategy (There Is No Alternative but to go beyond Treasuries). In this scenario, investors feel compelled to choose common stocks, high yield bonds and other assets that carry a greater degree of risk than Treasuries. The choice investors have come to make is, does one accept a yield no greater than inflation in Treasuries, or does one take on more risk?
The risk can emerge when the well of foreign central bank bond purchases runs dry, as it must at some point. After all, what is unsustainable always ends, and sometimes ends badly. With that in mind, the risks apparent in pricier assets may potentially indicate that yes, a little bit of worry can help avoid unnecessary risks. After all, the paradox revealed in our discussion is that the less worried investors are, the greater the risk they undertake.
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