Still Just A Panic Attack?

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by: Calafia Beach Pundit

A few weeks ago, I opined that the sudden equity selloff was just another panic attack and unlikely the start of a major rout or a harbinger of another recession. It's now turned into an official correction, with the S&P 500 down 10% from last month's peak. Has anything changed to make the prognosis worse? Lots of things have changed, mainly equity valuations (which have improved significantly), but the underlying fundamentals are still healthy and, therefore, at odds with the market's apparent level of distress.

Nine months ago (January 26th), the market was enthusiastic: the P/E ratio of the S&P 500 (using Bloomberg's measure which counts only profits from ongoing operations) was just over 23. Today, despite the fact that profits have since risen almost 16%, that same P/E ratio has fallen over 20% and now stands at 18.5. That's quite remarkable, considering the market currently expects profits to grow by another 25% over the next 12 months, which would imply a forward P/E ratio of a mere 14.7, significantly below the market's long-term average of just under 17 (see charts below). In short, the market has gone from enthusiastic to very worried in a relatively short time frame. To judge from these metrics, while a recession seems very unlikely in the next year, beyond that the market appears to have lost all confidence.

The causes of this dramatic turn of events are many, and I'm now going to sum them up as "global angst:" a weakening Chinese economy, budding tariff wars, concerns about Fed tightening, a fragile eurozone, weakening emerging market economies, rising oil prices, all coupled with the fact that we are entering the 10th year of an economic expansion (which by itself makes investors quite nervous - how much longer can the good times last?). None of these factors have appeared out of the blue, however; they've all been headwinds for a while, but it seems they have rather suddenly combined into something like a perfect storm.

Equity valuations have plunged, but it's hard to find any evidence of a sudden or imminent economic downturn. In fact, financial market and economic fundamentals remain solid: swap spreads are low (which implies low systemic risk and abundant liquidity), credit spreads are up only slightly from relatively low levels, the yield curve is still positively sloped and real yields are still relatively low (which together imply that the Fed is far from being tight), the dollar is reasonably strong, and inflation expectations are reasonably anchored. The Powell Fed has given no hint of being willing to ignore the market's sudden distress in pursuit of an aggressive tightening agenda, and I seriously doubt they would do so anytime soon.

So, it seems this is still in the nature of a panic attack, and as such, it should pass. But of course, there are events that can pop up that are unpredictable, and investors must always shoulder the burden of the unforeseen. If you can't take that heat, you shouldn't be in the market.

Here are some updated charts which flesh out the story:

Chart #1

Chart #1 illustrates how all of the market selloffs in recent years have been accompanied by a sharp rise in "worries." For "worries" I use the Vix index divided by the 10-year Treasury yield. The Vix index rises as fear rises, while the 10-year Treasury yield tends to rise as confidence in the economy rises. We've seen much more serious levels of worry in recent years than we see now.

Chart #2

Chart #2 shows that swap spreads, which are a key coincident and leading indicator of financial market and economic health, remain relatively low. At 20 bps, US swap spreads are fully consistent with healthy and liquid financial markets. At the same time, they tell us that systemic risk is low. Liquid financial markets are a sine qua non for a healthy economy. No problem here.

Chart #3

Chart #3 shows the level of real and nominal 5-year Treasury yields and the difference between the two, which is the market's expected annual inflation rate over the next 5 years. Inflation expectations today are very close to the Fed's 2% target. No problem here.

Chart #4

Chart #4 compares the level of 5-year real TIPS yields with the real Fed Funds rate. This tells us that the real yield curve is positively sloped, and the market is not concerned that the Fed has tightened too much. The time to worry is when the blue line exceeds the red line, as that would be an indication that monetary policy was too tight and the Fed would likely be force to cut rates in the future. That's not the case today. At worst, the bond market is telling us that perhaps the Fed will need to move rates up more cautiously in the future. That's not a problem.

Chart #5

Chart #5 shows 5-year Credit Default Swap Spreads. These are highly liquid and generic indicators of the market's confidence in the outlook for corporate profits. These spreads have increased only modestly despite the sharp equity selloff, which further suggests the market is still confident in the outlook for corporate profits and the health of the economy. No obvious problem here.

Chart #6

Chart #6 shows Bloomberg's measure of the S&P 500's P/E ratio, which uses profits from continuing operations. Since January of this year, P/E ratios have plunged from 23.3 to now 18.5 (-20%). This reflects a rather sudden loss of confidence in the long-term outlook, especially considering that profits continue to rise. Curiously, the bond market appears to be much more confident about the future than the stock market, given the low level of swap and credit spreads. This further suggests the equity market may just be in the throes of a panic attack.

Chart #7

Chart #7 compares two measures of corporate profits: after-tax corporate profits as calculated in the National Income and Product Accounts (red line), and after-tax earnings per share based on a 12-month trailing average of reported quarterly earnings. Both are at all-time highs and rising. No problems here.

Chart #8

Chart #8 shows the Fed's preferred measures of inflation, based on a broad measure of personal consumption. Both total and core inflation are very close to the Fed's 2% target. No problem here.

Chart #9

Chart #9 compares the real Fed funds rate (a good measure of how loose or tight monetary policy is) with the slope of the Treasury yield curve. Recessions have always been preceded by a substantial tightening of monetary policy and a flattening or inversion of the yield curve. We're a long way from those two conditions today.

Chart #10

China has taken a beating in recent years, and especially this year, which has seen the steepest-ever drop in the value of the yuan. This has occurred in tandem with a decline in the Chinese central bank's holdings of foreign exchange reserves, and both are symptomatic of capital flight. Capital is leaving China because investors are worried about the future of the country's economy. In a relative sense that's good for us, but if China were to fall off a cliff, well, that would not be good. China is the biggest concern in the world right now, but their leadership could fix that problem by simply acquiescing to Trump's (and the WTO's) demands: respect intellectual property rights, and reduce or eliminate tariffs and subsidies. In short, China's outlook would improve dramatically if they simply adopted sensible policies. How hard is that?

Chart #11

Chart #11 compares the Chinese and US stock markets. Note that both y-axes have the same ratio between top and bottom values (15x), and both use a semi-log scale. China's stock market has truly plunged since January of this year, suffering a punishing loss of almost one-third of its value. Worse still, the country's stock market today is trading at close to the same level as it was over 20 years ago, whereas the US market has risen 460% over the same period. Big problem for China. Free market-style reforms could do wonders for China's wealth. What's good for China would be very good for the rest of the world.

What stands out in all of this is that equity market fears are not supported by any deterioration in the economic and financial fundamentals, at least in the U.S. economy. That could always change for the worse, but for now it's still in the realm of speculation.