What Exactly are Stock Markets Trying to Price? Some Perspective.

by CC August 9, 2011 2:14 am • Commentary

It’s starting to feel like ’08 out there, huh? But is it anything close yet? There’s not alot of debate about what exactly is causing the freefall in stocks across the globe right now. Most market observers agree it’s been a combination of global recession fears, debt fears in Europe, particularly worries about Spain and Italy, and then the kick to the nutz that was the S&P downgrade that followed the protracted ’til the 11th hour debt ceiling deal. I want to look at a couple of charts here to understand exactly what markets other than stocks are telling us about a few of these fears. First here’s a 5 year chart of TED spreads.

The TED Spread is an indicator of perceived credit risk in the general economy.When the TED spread increases, that is a sign that lenders believe the risk of default on interbank loans (also known as counterparty risk) is increasing. Interbank lenders therefore demand a higher rate of interest, or accept lower returns on safe investments such as T-bills. When the risk of bank defaults is considered to be decreasing, the TED spread decreases. (Wikipedia)

From Bloomberg:

5 yr TED Spreads

I did a 5 year chart here for perspective. Right now, we’re on that itty bitty little uptick on the far right. In fact, the TED spread was down 8% today to 23.4… the historical average is about 30. During the banking crisis in ’08, the spread hit 460!

Next, let’s talk about Spain and Italy. Here’s are charts of Spain and Italy’s 10 Year yields. First Spain:

Spain 10 yr

And now Italy:

Italy 10 yr

So in both cases the news lately has cause upticks in their yields, but only from 4-5ish up to 5-6ish. For some perspective, here’s Greece:

Greece 10 yr

Greece went from that 4-5ish range to as high as 17!

So what about the S&P downgrade of U.S. debt? Here’s a chart of our 10 year yield:

US 10 yr

As expected, the downgrade caused our yield to go up as worries about us being able to pay off our obligations… oh wait, no they didn’t. They continue to go down.

So what’s the larger point here? Basically, unless something changes in these debt and lending markets soon, they are indicating that this sell-off is almost entirely the stock markets trying to get ahead of a global slowdown that may already be happening. All these other things in the news are beside the point, at least for the moment. But the thing is, all this talk of potential Italian defaults, and U.S. downgrades and everything else that fills up financial media becomes a self fulfilling prophesy. Not that they themselves are significant yet, but all the talk is really bad for the ‘animal spirits’ of a really fragile global economy. One that, by the way, has yet to be shown to be an actual recession yet. Only the worry of one based on slowing growth barely above flatline. Of course, those recently reduced GDP numbers could be wrong. Here’s some more perspective on just how bad ’08 was and how little we knew about it at the time:

Output in the third and fourth quarters fell by 3.7% and 8.9%, respectively, not at 0.5% and 3.8% as believed at the time. Employment was also falling much faster than estimated. Some 820,000 jobs were lost in January, rather than the 598,000 then reported. In the three months prior to the passage of stimulus, the economy cut loose 2.2m workers, not 1.8m. In January, total employment was already 1m workers below the level shown in the official data.

So the question is, how likely has that recession now become, how bad will it be if it does happen, and where does the stock market have to sell-off to to price in those factors? I have no idea what the answers to these questions are, but I do have the sense that since ’08 is so fresh in people’s minds, they don’t want to be around in the markets to find out.