President Franklin Delano Roosevelt’s first inaugural address is remembered to this day, almost 90 years later. March 1933 was near the depths of the Great Depression, and he knew that he needed to set a more positive tone for a nervous nation. Talking to the nation using the relatively new technology of radio, his speech contained a line that still resonates: “the only thing we have to fear is fear itself.” That certainly does not describe the current market environment, but I would flip FDR’s idea on its head. The thing that investors have to fear most is a lack of fear itself.
Experienced investors know that the statement is not as absurd as it sounds on the surface. Stock prices are rooted in expectations: expectations for higher sales, higher earnings, lower rates, a stronger economy, etc. As expectations ratchet higher, investment flows follow. This is a virtuous circle under normal circumstances. Participants in the economy become more confident in their own welfare, markets become more confident as people spend money on the goods and services provided by companies, and the cycle repeats. But every cycle runs its course. The questions are when and how?
A recent example of the lack of fear causing a crisis came in February 2018. In the months leading up to that date, equity markets had been moving steadily higher, buoyed by a solid economy and the prospect of tax cut legislation. Every day seemed to bring a higher market, even after the tax cuts were signed into law in December 2017. The VIX index seemed to be plumbing new lows on a daily basis during this period, as investors became increasingly sanguine about the markets’ continued prospects. That all came to a crashing halt in early February. Major indices plunged over 10% that month and the VIX index more than tripled from its lows. The consensus became too broad that markets could only improve and do so in a controlled manner. The news at that time was uniformly positive for equities, yet expectations surpassed the immediate reality.
Flash forward to the present. The Federal Reserve remains committed to providing liquidity even as a $1.9 trillion fiscal stimulus package makes its way through Congress and Covid-19 vaccines are being injected into increasing numbers of arms. That is a truly awesome setup fot the economy. Can it get any better than that? It’s hard to say. Expectations for a robust economic improvement are already priced into a broad range of investments. Can they improve markedly enough from here to provide another push to the virtuous circle?
The bond market, which is admittedly the dour sibling of the equity market, is starting to question if we have reached a limit to the good times. The recent rise in inflationary expectations has led to a lift in 10-year Treasury note rates. I think the speed of the rate rise was linked to disappointment that the Fed did nothing to quell the long end of the yield curve. I heard of investors expecting them to do that when we crossed 1% and then 1.25%, but there was no evidence that the Fed moved to suppress long-term rates. Equity markets reacted nervously at first but seemed to find more comfort with the current rate levels during yesterday’s impressive rally. I do not see a huge risk to the equity markets when those notes yield a mere 1.4%, but last week we actually saw 10 year rates exceed S&P 500 dividend yields for the first time in quite a while. Part of the allure of equities is the concept of TINA – an acronym for “there is no alternative.” What happens to stock valuations if and when there is an alternative?
Last week, I wrote about some of the fear that VIX futures traders were pricing into their estimates for this spring. My hypothesis is that it is a combination of investors’ need to liquidate some of their holdings to pay taxes and a fear that fiscal stimulus could prove to be another “buy the rumor, sell the news” event like we saw in February 2018. As of now, most of the market’s fear is being displayed by bond and volatility traders. Is that sufficient to compensate for the lack of fear shown by the rest of the market?
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