Climbing Walls of Worry

The old saw “the market climbs a wall of worry” has never been more apropos.  The economic outlook hasn’t been so plagued with question marks since the throes of the financial crisis.  Consider the following unresolved issues:

  • Will the new president be able to garner enough Congressional support to pass a new health care bill, a trillion-dollar infrastructure plan, increases in military spending, and tax cuts for both businesses and individuals?
  • Will Republican “deficit hawks” in Congress support actions that will undoubtedly lead to higher budget deficits (at least in the short term)?
  • Will aggressive fiscal stimulus combined with near-full employment force the Fed to raise interest rates more quickly than they would like?
  • How well will the economy withstand rising interest rates after 8 years of near-zero short-term interest rates?
  • Will higher interest rates negatively affect sectors of the economy heavily dependent on credit (housing, autos, durable goods, etc.)?  How about financial assets prices like stocks and bonds?
  • Will the side effects of Trump’s proposed policies (higher deficits, higher inflation, higher interest rates, stronger dollar, a reduction in trade) outweigh the benefits?
  • How will our trading partners react to a possible Border Adjustment Tax?  Will widespread trade wars materialize?
  • Will the proposed restrictions on immigration be counterproductive for economic growth given the formula that economic growth equals productivity growth plus labor force growth?
  • Will the wave of populism and nationalism we saw in the Trump election and Brexit vote continue in the Netherlands and France, leading to the disintegration of the European Union?

Yet even with all these worries, we haven’t had a meaningful correction (10% or more) in over a year.  Now over 8 years old, the bull market has seen the S&P 500 rise 250% from its low on March 9, 2009.  At the same time, the CBOE Volatility Index, or the VIX, is running at levels that signal very little investor concern about an imminent correction.  One way to gauge the level of complacency is by tracking the ratio of the S&P 500 Price-to-Earnings ratio (P/E) to the VIX.  In the table below, we show that this metric is running at its highest levels since 1993!  According to a March 8 article from Bloomberg, “In the past 12 months, the S&P 500 has spent only 23 days rising or falling 1 percent, compared with 85 days during the eighth year of the 1990-2000 run.”  What’s even more remarkable, this market stability is happening at a time when the Federal Reserve is increasing interest rates.  Prior to the last twelve months, the very mention of monetary-policy normalization would send the markets into a hissy fit.  Instead, the waters are calm and there don’t appear to be any storm clouds on the horizon.  What do we make of this?

*Source: Bloomberg

There is no doubt that optimism and complacency are running at high levels right now.  Economic indicators have firmed up a bit recently, but it remains far from clear that there will be a seamless transition from 8 years of ultra-loose monetary policy to fiscal stimulus.  And the risks are evident on both the upside and downside.  In other words, some economists believe that enacting aggressive fiscal stimulus now, at a time of near-full employment (debatable) and increasing inflation, could lead to a surge in inflation that will force the Fed to increase interest rates at a much faster clip.  Others (myself included) think it is more likely that Trump’s fiscal stimulus and other “pro-growth” initiatives will be slow to materialize (due to political gridlock) even as the Fed continues to raise interest rates.  The economy’s heavy dependence on low interest rates for the past eight years will likely cause growth to peter out as the lion’s share of the middle class continues to struggle with high debt levels, scant increases in income, and inadequate retirement savings.  It is hard to fathom that the Trump administration will be able to engineer a goldilocks outcome of not-too-hot and not-too-cold.

Now is a time for caution.  Markets are anticipating a benign economic outcome that is unlikely to materialize.  From a technical perspective, complacency is very high, volatility is very low, and we haven’t had a meaningful correction in stock prices for quite some time.  I continue to be very cautious and defensive as I await better visibility.