Hey, I love bashing the French as much as the next guy, but I just can’t bring myself to really blame them (or the rest of Europe) for our current situation. Clearly, some recent market volatility can be attributed to endless European debt woes, but the US economy remains the primary driver of US market direction; as well as global risk seeking/aversion behavior. A bitter cocktail of persistant high unemployment, a massive Fed balance sheet, ad-hoc banking regulation and political uncertainty is what ails US markets. One need only take a long term view of some markets to understand my point.
The green line is the Dow Industrials and the black dashed line is a NAREIT index (both on a log scale). The blue line is the TED spread (3 month LIBOR less 3 month T-Bill rate). The red line is the 3 month T-Bill, inverted (so it’s easier to see the relationship to equities.
Here’s my analysis:
TED Spread: When there is a serious financial crisis, the TED spread explodes. You can see spikes during the 1987 crash, the first Gulf War, the Russian debt default, and the most acute phase of the finical crisis during 2008. Yes, there has been an increase in the TED spread during the European debt crisis. But, as the graph shows, we’re not anywhere near crisis levels. Yes, the world’s central banks are already doing everything they can to flood the world with dollars, reducing the chances for a spike in USD rates. If the European banking system were collapsing, however, risk aversion would be out of control and demand for dollars would, at least temporarily, overwhelm the central banking system. While a serious crisis might yet erupt, we are not there yet.
3 Month T-bill/Equities: Contrary to popular believe, risk assets are a better buy when interest rates are high. As the chart shows, in the early 80′s the 3 month T-bill got over 15% and the Dow Traded below 1,000. 18 years later, at the height of the NASDAQ bubble, 3 month T-bills were around 6% and the Dow was over 10 times higher, trading over 11,000. Since that bubble burst, you can see how asset prices seemed to trade almost entirely as a function of interest rates: the Fed cuts to 1%, stocks rally; rates go up, and stocks go down. For a couple years now, however, rate have stayed pegged near zero, and stocks remain relatively high. Stepping back, we can see that assets should offer higher returns when risks are higher. If asset prices remain high during a time of high risk, I would have to say assets are “miss-priced.”
Bottom line: If the Europeans truly sort out there mess, stocks should rally. But, over the long haul, the US economy needs to generate higher rates of growth to justify higher rates of return. It’s really hard to imagine asset markets replicating anything close to the massive bull run over the last 25 years with a starting point of 0.1% T-Bill rates.
Who am I kidding, I just wanted to play with my new graphing software! Link to the Original