Large Cap U.S. Stocks Are Low Risk Investments

Includes: DIA, QQQ, SPY
by: Daily Trading

How bad is the current global financial crisis (or whatever it is that you call it)? Well, believe it or not - if you take out the GFC of late 2008, it is no worse than any other crisis that we have experienced in the last 20 years. Yet the average punter/investor has essentially priced in a repeat of the GFC of 2008, and every expert in town is suggesting on no uncertain terms that "this time it is different".

Below is the Bloomberg Financial Conditions Index. It is essentially comprised of spreads between risky and less risky assets like yields on junk grade corporate bonds vs. investment grade corp bonds, emerging market debt vs. US Treasuries, currency risk reversals, swap spreads, equity volatility and a whole host of other indicators which give one a good appreciation of the level of financial stress/panic in financial markets.

Note that current "stress" levels are less than they were during the LTCM crisis and they are not any greater than they were at any time during the bear market from 2000 - 2003. Stress levels are also a little less than they were in late 2007- mid 2008.

Bloomberg Financial Conditions Index (click to enlarge images):

Now this is where things get really interesting. Although the stress in the financial system isn't any greater than that which occurred at anytime since 1994, the crowd has priced financial assets as if there will be at least a repeat of the greatest financial crisis this side of The Great Depression (the GFC of 2008). In short: Moms and pops have completely overreacted to the euro debt crisis.

OK so why has the "back end of the market" not broken down and why have moms and pops priced in a repeat of the GFC? The answer to these questions can be summed by this: Because the GFC occurred just three years ago. Let us not forget that the S&P fell by some 50%, the global financial/banking system stopped functioning and every person on the planet was staring down the barrel of a repeat of horror of the Great Depression.

The back end of the market hasn't frozen up like it did during the GFC because central bankers are paranoid of the consequences letting "liquidity" dry up! Moms and pops have overreacted because they are still too shell shocked by the GFC. As I have stated many times before - peoples' actions today in anticipation of another GFC happening will ensure that it does not happen. At the start of 2008, moms and pops were more or less fully invested in the stock market. Now they are perhaps the most under-invested they have been in at least 30 years.

Earnings yield differential between the S&P 500 and the US 10 year:

Yes, this time it is different - there are fewer marginal sellers left to push equity prices lower and Treasury prices higher. Large cap US equities are considerably less risky than the press of popular opinion is making out.

Disclosure: I am long DIA.