S&P 500: market narratives and the wall of worry

by George Hatjoullis

Discounted Cash Flow Calculator - is a tool to...

Discounted Cash Flow Calculator – is a tool to help estimate the present value of a stream of free cash flows discounted to the present. (Photo credit: Wikipedia)

Every regulated financial product carries the reminder that past performance is no guide to the future. Yet every financial analyst mines past data in order to understand the direction of market prices. Even the most elementary research text explains carefully that correlation is not causality and that correlations can be misleading. Yet every market analyst will use past correlations to justify some view of the present and future. Other analysts concentrate exclusively on ‘fundamentals’. These analysts implicitly assume there is an independent and absolute valuation that can be ascribed to an asset. Moreover, in William J. Baumol‘s terms, ‘true value will out’. In short, given time the fundamental value will emerge and short-term market irrationalities should be ignored. Gillian Tett illustrates all these ways of thinking in the FT today ( http://on.ft.com/18PaQgO).

In reality markets can remain ‘irrational’ a lot longer than you can stay solvent. The capacity for markets to deviate from what analysts believe to be true value is quite extraordinary. As I have noted in earlier blogs, success in financial markets is all about understanding the prevailing market narrative. These are loosely connected to reality but for long periods the connection can be non-existent. The narratives set up waves of collective action  and these sustain trends. To be successful in financial markets investors need to grasp which narrative is in play and act accordingly. However, this is easier said than done as, living in the real world, investors are often sidetracked by facts and other noise.

In my previous blog, ‘Non-farm payroll and the S&P 500: which narrative?’  (http://bit.ly/15S93bZ)  I offered an outline market narrative that could justify a continued bull market. It is worth re-reading or simply reading [Also see ‘seasonal narratives in equity markets’ ( http://bit.ly/Z0qLXG) ]. I noted the importance of investment positions in relation to potential and desired holdings and indicated that the capacity to hold more equities was considerable. It would seem that my narrative is in play.

The markets are making new highs and bringing more investors into the game. It is a bull market. Anxiety is high because the rally does not fit the past data, correlations or market analyst estimates of  ‘fundamentals’. The market, we say, is climbing the wall of worry. This is quite common in the middle of  a bull market. The time worry is when no one is worried. The time to worry is when the taxi driver gives you stock tips. The time to worry is when you hear ‘it is different now’. It is never different.

Asset values are of course relative not absolute. The usual fixed point of reference is the risk free asset. However, supplies of risk free assets have shrunk. The eurozone crisis rendered much eurozone debt non-risk free. The banking crisis rendered cash in excess of the insured amount non-risk free. Indeed, given that the insured amount in a systemic crisis becomes the liability of the state, there are some states in which even the insured amount is not truly risk free. The sovereign debt of a few states has been highly sought because, ironically, the capacity to print money rendered the debt nominally risk free [For the inflation nervous these states also provided index-linked debt].  It is ironic because the operation of money printing through Quantitative Easing removed many risk free assets from the system and replaced these assets with liquidity which was harder to safely locate. The lack of ‘safe’ assets saw gold and commodity prices benefit though as many held merely derivatives and not physical, the safety element was partly an illusion.

The important message to take here is that the risk free interest rate collapsed through excess demand. It is still very low. Assets are merely claims on future cash flows. The present value or price is merely the discounted value of these prospective cash flows. The discount rate has two conceptual elements; a risk free interest rate and a risk premium. The risk free rate represents the alternative of just holding a risk free asset. It is all relative. The risk premium represents an additional amount to compensate for the perceived riskiness of the cash flow. In the early stage of the crisis the risk free rate collapsed but the risk premium rose because of the catastrophic market narrative that emerged. Over time the lack of catastrophy has reduced the risk premium but the risk free rate has remained rock bottom. The discounted value of prospective future income streams has risen. In order to illustrate consider a perpetual bond yielding 6%. The present value or price is {1/0.06} or 16.7. If this rate falls to 1% then the present value is 100.

The collapse in the price of gold and other commodities has in part been caused by a fall in risk perception. This is why equity prices and commodity prices have diverged. The equity price has benefitted from the lower risk premium this has elicited. Monetary authorities also seem to be inclined to err on the side of caution and only allow the risk free rate to rise slowly. The discount rate is thus declining and allowing asset prices to grind higher through the wall of worry. The risk to equities will come when the risk free rate has more scope to rise than the risk premium has to fall. Ironically this is likely to be at a time when economies are booming and bringing in their wake the fear of inflation. We are some way off this narrative methinks!