On August 17th, 1998, the Russian government, decimated by falling oil revenue resulting from the Asian financial crisis, devalued the ruble, defaulted on its domestic debt, and declared a moratorium on payment to foreign creditors.
The S&P 500 was almost in familiar territory — 1062, and had already fallen more than 10% in anticipation.
By early October, the stock market had declined another 14%, and the 10-year US Treasury yield had declined by 152 basis points in the span of 6 months. The VIX hit an astounding 45.74 — eclipsing the implied volatility from the crash of 1987.
Economic conditions in Russia did not begin to recover until 2000, and were not at the previous nominal GDP peak until 2003, 5 years later.
Fast forward 13 years: in the 3rd straight decade (1990s, 2000s, 2010s), we are flirting with 1120 S&P 500, the 10-year US Treasury yield has declined by 148 basis points in the span of 6 months, and the VIX is at an astounding 42.99.
The restructuring of European periphery debt — to which its neighbours are intimately connected, much like a dozen years ago — hasn’t happened, but it’s difficult to say that the market hasn’t already clearly priced that as likely already.
This is all really bad news, right?
After the market had its watershed moment, it finished the year 33% higher. The market, seeking resolution even in bad news, was able to quickly eclipse its previous highs and rally strongly for several more years.
Equities are now cheaper than they were in 1998, or even 1987, 2002 & 2008 by measurement of Equity Risk Premium (earnings yield minus risk-free yield) of 5.86%. The last time the ERP was this large, 1975, earnings actually declined 18% while prices rose 32%. The significance of the equity risk premium is doubled with nominal rates so low: pension funds, insurance companies & other institutions require 6-8% annual returns to be solvent, and with the 30-year UST yielding a minuscule 3.54%, it is difficult to see how they can achieve this without substantial allocation to more risky assets. They buy, or have shortfalls. (I’m assuming there will be examples of both)
At the same time, the massive pressure in US Treasuries from not only domestic, but also foreign, purchasers to provide more dry powder than the S.S. Mont-Blanc parked in the Halifax habour. The relationship between equity prices and bonds is highly mean-reverting, and has provided an extremely consistent and profitable buying signal once it is stretched. The Relative Strength Index Difference between the two has been is now below -50 — something which has only happened 4 times before since 1960. In each occasion, it has posted strongly positive 1, 3, 6 & 12 month returns. Even in less extreme conditions tested, it is very reliable:
RSI Difference 1-month %-winners 3-month %-winners 12-month %-winners -50 100% 100% 100% -40 79% 70% 60% -30 68% 73% 68%
So far in this earnings season, the S&P 500 has a 91% beat rate, and has smashed top-line, bottom-line & operating margin estimates. There are more than 1.2 million jobs from 12 months ago, 40,000 less per month applying for initial unemployment insurance, and consumer credit rose a mammoth 15.5% (annualized) last month. The big knock since November on consumer credit was the lack of participation in non-government, revolving credit — we’ve now posted two straight monthly gains in those categories. The pace of Commercial & Industrial loans is up $55B in 9 months. The financial stress indices from 3 Federal Reserve branches, which indicated in the past with months of notice on lending contraction, have been in solidly negative (improving) territory for months. The end of the dreaded de-leveraging seems in sight.
Ultimately, the market is anchored to the fundamentals of the economy (anyone claiming otherwise has not seen the chart below), which are improving. Expectations being priced into equities now imply an earnings decline of 30%+.
The same sort of panic, also rooted in Europe, happened last year to nearly the same degree. The fundamentals drove us back to reality.
Now, with the debt ceiling deal relieving the fiscal pressure on the large portion of the country who are on the receiving end of public sector flows, Japanese industrial production finally rebounding post-tsunami, and with inflationary pressures sharply declining (which is a direct consumer stimulus)….
The volatility may not be over, but even bad news will be clarifying – like the Russians defaulting in 1998.