The Fat Pitch


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 to, 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 miniscule 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% (annualised) 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.

Batter up.

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13 Responses to The Fat Pitch

  1. dasan says:

    i’m not the only lunatic that thinks in retrospect, this may appear an incredible buying opportunity. Everyone assumes we are in September 2008- I agree that 1998 is a much better analog.

  2. dpowen says:

    Unprecedented gov interference in today’s markets coupled with capitalism encountering structural headwinds as frontier markets dry up into developed ones leaves me wondering how strongly we can draw on the past for comparison.Definitely not a general buy and hold opportunity but as you astutely point out, a well planned shopping list and timely execution may see genuine home runs on any instruments over a 5-10 yr horizon and beyond.

  3. The_Analyst says:

    Damodaran has the ERP even higher at around 6.6% as of a few days ago for what its worth.Check out the studies at the beginning of the CS Global Equities Yearbook, interesting stuff on ERP, yields, inflation, and all this fun stuff…

  4. David Lewis says:

    Easy money will drive all prices higher in the next year or so…….then all bets are off as the US simply cannot stand higher rates – too much debt. As long as we can borrow I think we are OK and when the world won’t lend us money at a reasonable rate watch out.David Lewis

  5. Matt Busigin says:

    David,”Easy money” is only tenuously correlated with prices. It’s all about wage growth – inflation converges on it EVERY time. See: the empirical evidence shows, Fed policy actually bumbles around with pretty minimal elasticity to price, particularly after 1980.This is because a shortfall in the demand for money makes changes in the quantity & cost of money far less meaningful. At this point, they are nearly unrelated.As for borrowing, the Fed sets interest rates, and every dollar which is borrowed ends up as a deposit in the banking system – which ends up as an excess reserve. So there are no fiscal or mechanical constraints on our ability to run deficits.Please read Randal Wray’s article from yesterday on the subject of monetary mechanics:

  6. Matt Busigin says:

    To be clear on excess reserves — unless they are displaced by the Fed, they end up as UST purchases, completing the cycle. This is why the deficit is so strongly correlated with the value of the US dollar. See the Macrofugue piece on the subject:,Matt

  7. naufalsanaullah says:

    definitely agree market is providing some opportunities at these levels (although not necessarily even as recently as a week ago)… been buying aapl, bidu, cmg, qcor, cf, idcc, mfn, msft, ibm, bsft this week. covering some shorts, holding others.but i think that any bounce from here will be temporary (although not necessarily short-lived.. the 2001-2002 bear market bounce stretched seven months) and don’t expect the market to recover 1300.i think we will get a boost in economic output indicators in q3 to drive this bounce. auto sector is showing some positive signals and should help that. as should the decline in oil prices. but i think it will only set up for a further decline in q4.if you look at gasoline prices, they haven’t been as volatile (or contracted as sharply) as crude prices– in fact, as they hold the current 270 level (if risk goes higher from here, it should– that level breaking would correlate to new lows in the equity markets), they are still in the area/zone/base one would consider as sharply higher from last year. the recent risk dip did not change the underlying gasoline price trend.the financial stresses in the eurozone are becoming increasingly acute. a short-sale ban really is a big deal. very structural changes have to happen to either the eurozone, or the attempted rescue package(s) for the multiple periphery fiscal crises, and both involve a level of uncertainty that definitely is not priced into markets for long term. its becoming increasingly clear that germany is going to have to give in, one way or the other, and this just as its export boom could be peaking. not to mention the central & eastern european mortgage issues, given all of these chf-funded loans, how are cash flows looking with chf/huf and chf/pln so high? either way, the banking crisis has not let up by any means.the us is having bank issues of its own, but its contained to a single bank, bank of america, and the lack of real acute crisis in americas banking system may be getting priced back in as extreme sentiment normalizes. nevertheless, the banking system has lost a big revenue generator from trading, as recent bank earnings can attest, and their balance sheets still don’t get a lot of face value respect from investors. no yields in government securities up to 2yr tenors now are only a further negative.the real concerns of mine are that 2011 marks the transition into a new structural phases for the two largest and most important economies: china and the us. china is ushering its new five year plan and will be attempting to rebalance with the backdrop of declining (and ultimately reversing) credit growth, a key (i would say vital) part of the stimulus-led recovery of growth and especially asset prices in china.with respect to the united states, we are entering a phase of contracted government spending capacity. the war of words on the credit rating agencies will likely intensify from various western governments, including the united states’, but a second downgrade from s&p would be substantive. not to mention, mathematically this is not a sustainable course. the reversal in government spending is likely to be damaging to both growth and, more importantly, labor. sub-2% real gdp growth for the next 3yrs+ does not seem so ridiculous to me.and the geopolitical risks are rising by the day. cameron considering a “social media ban” in light of the riots is a sign of the times, i guess. the african horn famine is increasing in severity with alarming quickness. dprk and the rok have exchanged munition fire across the yellow sea, as the north korean provocations continue into 2011. syria’s situation has yet to have been resolved. etc etc etci think we are in a combination of 1998 and early summer 2008. the fed has lowered 2yr rates to zero, i expect a financing boom for tech. similar to the ltcm-driven liquidity injection that chased tech stocks in 98 and led to the parabolic phase. ive long been looking for cloud tech/social networking/big data to go bubbly and we may start getting the funding for just that, now. at the same time, i think the overall markets are going to start making lower highs and lower lows… stairstep up, elevator down style. all this while oil goes up, similar to summer 2008. some stocks perform very well, others an aside, i think eventually we head down sizably. could be in 2012-2013. could be 2014-15. but eventually rates will rise. and they will rise as soon as japan’s start rising. and they will, as a function of demographics and capital flows. japans largest pension fund is selling jgb’s, let’s not forget. as soon as the japan deleveraging scenario is shown to eventually lead to rising rates in its final scene, the bond vigilantes will drive us rates higher. the chinese rebalancing away from export dependence is going to eliminate the intrinsic support for ust’s that would prevent such bond vigilantes from driving yields up substantially in the past. once yields rise, all sorts of interest rates risk on all sorts of balance sheets (household, corporate, financial, all the way up to sovereign and central bank) come to roost. we’re getting hilariously meager growth with the developed at zirp (fed 0, snb 0, boj 0, ecb .5% etc). imagine what things are like when rates rise.

  8. naufalsanaullah says:

    jeffrey gundlach for president. hilarious that he called for s&p 500 to go to 500.“Though I rarely go public with specifics on stocks, I think the Standard & Poor’s 500, which is now over 1300, will hit 500 in the next couple of years,” he says. “I usually couch my belief by saying merely that 2011 will be a tough year for equities.”

  9. praxis22 says:

    The Russian default was the reason I got into economics/finance back in the day. Back then Greenspan lead the charge to have Wall St. ibanks recapitalise a private firm, (LTCM). With the notable exception of Bear. Which was why the Fed had to give them a bridging loan for a shotgun wedding at the start of the crisis, nobody would lend to them.Nobody ever complains that this is government intervention in markets, least-ways not when you’re getting a bail out, and having your hand held toward the exit. I’ve no doubt the market will go back up again, what is the point of delayed consumption if you’re not getting compensated, (6% on average) to “invest” doesn’t mean the whole thing isn’t both hypocritical and crocked. Far as I can tell, everything, from money on up, is a scam, one that works only because people believe in it. Hell, most people don’t even know what money is, try it some time, walk up to somebody on the street and ask them them what money is, most amusing 🙂

  10. Rantly McTirade says:

    This guy’s enough of an ignorant twit that he could be a hack TV shill. Best be sure you’re out of public view by this time next year, genius.

  11. Hypnosis Hypnotherapy Los Angeles says:

    It is amazing, the different figures and varying conclusions reached by market watchers in general. Gold is going up, gold is going down. The Dow is going up… The Dow is going up/down first followed by going down/up later. And so on. hypnohotshot.

  12. lingsun says:

    The stock market is headed for a crash because the economy is headed for a severe depression. There are a lot of empty seats available on the Titanic right now. I don’t consider that to be a buying opportunity either.

  13. golf says:

    the differant between the Market and MY wife.Is that Market go down.

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