Today, I want to look at the state of confidence that exists in the financial markets. As usual, I have a few statistical measures that I rely upon to give me some indication of how investors are feeling in general about how they perceive the market.
As with other market measures I use, I must be candid in saying that what the market is trying to tell us might be wrong. Financial markets certainly have been wrong in the past.
However, the attitude I have found to be helpful in the past is to assume that the financial markets are correct in what they seem to be telling us and then go find out what it is that they are trying to tell us.
How deeply do you go in trying to find out what the market is trying to say? As deeply as you need to in order to feel confident with your analysis. Only after a thorough analysis do you consider that the market is wrong…and then you try and find out what the right answer is.
What I would like to concentrate on right now is general psychology of investors. My conclusion is that investors remain relatively confident in the financial markets and this provides a buoyancy to the bond markets and an underlying strength to the stock market.
The specific measure I use to examine this confidence is the ratio of yields on Moody’s Aaa bonds and Moody’s Baa bonds. The closer this ratio is to one, the more confidence is being exhibited by investors. The rationale for this is that companies with Baa-rated debt do not have to pay a significant risk premium over what a company with a Aaa-rated bond has to pay.
In other words, market participants are not fearful that lower-rated debt will default much more often than higher-rated debt.
A similar index is produced by Barron’s weekly. Barron’s index is called the Confidence Index and it is the ratio of Barron’s high-rated debt and Barron’s Intermediate-rated debt. The rationale for this measure is the same as the one using Moody’s numbers.
For both measures of confidence, a low was reached in April 2013. Both confidence measures rose through the rest of the year into January 2014.
A trough in the confidence measure was reached in April 2013 at 81.31, but this low was reached due to unusual circumstances.
Up through April 2013, risk-averse money had been flowing into the United States, particularly from Europe. I have written about this situation many times in my LearnBonds posts. At the end of May this situation reversed itself.
Beginning in May, confidence rose in European financial markets and this risk-averse money began to flow back to the continent. As a consequence, yields on longer-term government securities began to rise…the yield on the 10-year Treasury security jumped from 1.76 percent in April to 1.93 percent in May and to 2.30 percent in June.
A similar, but less dramatic rise occurred in the yield on Moody’s Aaa-rated bonds. The yield on Moody’s Baa-rated bonds also rose but by a smaller amount.
In essence, the yield spreads between all three of these securities narrowed.
This movement took place because the earlier distortions caused by the European money went away as the funds fled back to Europe.
The spread between the yields on Aaa-rated debt and Baa-rated debt continued to narrow throughout the year. The basic reason for this seemed to be that although longer-term interest rates were rising…because of the outflow of European money…the United States economy was improving and the Federal Reserve was continuing to supply an abundant amount of liquidity to the banking system.
Market participants did not see that much difference between the debt of Aaa-rated companies and the debt of Baa-rated companies. In February, the yield on the former debt was on 86 percent of the yield on the latter, up from 80 percent in early 2013. One could say that confidence was abundant.
Barron’s confidence measure performed in a similar fashion.
Another measure one can look at I call a measure of market liquidity. It is obtained by dividing the yield on the 10-year Treasury security by the yield on the Aaa-rated debt. I call this the Liquidity Measure.
The Liquidity Measure has also risen since April 2013. This measure was also impacted by the European money in the financial markets of the United States and a better reading could be gained once these funds started to leave the states.
The Liquidity Measure rose through January 2014. The conclusion one could draw from this is that there was plenty of money floating around in the financial markets and because of this the yield spread between Aaa-rated bonds and the yield on the Treasury issue fell.
One could make the argument, which many analysts have, that the credit worthiness of the government is not tremendously different from the credit worthiness of a Aaa-rated corporation. The major difference is that the government can tax and print money. Furthermore, the market for government securities tends to be a more liquid than the market for Aaa-rated corporate issues.
When the ratio between the yields on the governments and the yield on these corporates narrows it can mean that market liquidity is so great that the differences between government bonds and Ass-rated bonds becomes even less than usual.
The Liquidity Measure is telling us that there is ample liquidity in the bond markets and this means that the financial markets, right now, are in pretty good shape…even if interest rates do rise over the next year or so.
A lot of this market “tone” is coming from the actions of the Federal Reserve. And, this “tone” is likely to stay around even as the Federal Reserve continues to “taper” its purchases of securities from the open market.
In other words, the financial markets are very confident and are very liquid. This is a good sign for a healthy economy moving further and further into 2014.
About John Mason
John has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.