Posted on 11/06/2005 10:06:08 AM PST by ex-Texan
Financial markets have been eerily calm for most of the past two years. No longer.
IT’S not easy sleeping in the Buttonwood family home. The problem is not so much the traffic as the dogs: two affectionate spaniels who begin the night with the daughters and end it with the parents. There they lie, pinning your columnist under one-tenth of a duvet, until, suddenly heeding the call of nature, they stir, stretch, leap off the bed and tug her out the front door for an urgent visit to other parts.
In much the same way, volatility in financial markets is stirring from the mat again. On Monday October 31st, British equities had their biggest day in two-and-a-half years, rising by 2% thanks to some big takeover bids. Across the water, the week of Ben Bernanke’s nomination to replace Alan Greenspan as head of the Federal Reserve saw a steepish sell-off in bonds. The week before that, there was troubled trading in equities as central bankers bombarded the public with inflation warnings. In Japan, too, equity markets have moved relatively sharply of late. So too in emerging Asia.
Is all this just “noise”— in response to specific bits of news, such as better-than-expected personal-income figures or worse-than-expected earnings at Amazon and Boeing? Have investors been treading warily simply because it was October, a month haunted by the ghosts of crashes past? Or is volatility definitely on the increase? And why does it matter?
Volatility is the amount by which asset prices bounce about: the more they bounce, the more uncertainty, or risk, there is. It is “the probability of outlier outcomes”, as Howard Simons, a strategist at Bianco Research, puts it. One way to measure volatility is to look at how prices have fluctuated historically—their “realised” volatility.
Spreads on credit-default swaps (insurance contracts against the possibility that debtors will default) provide another indicator. The most commonly followed measure, and one which often moves before the other two, is the implied volatility in options contracts. Equities are generally more volatile than bonds and currencies. And it is here that volatility is stirring most noticeably now.
The Chicago Board Options Exchange’s Volatility Index (VIX) is based on a basket of widely traded options on the S&P 500. The more turbulence investors expect in the underlying shares, the more they are prepared to pay for options. The VIX is nowhere near the 45 that it hit in August of 2002 but, as the chart shows, it has been slowly rising since mid-July. Germany’s VDAX, an options contract on the DAX index’s 30 companies, has been trending higher too.
Volatility is important for several reasons. Many reckon that it can help to predict returns, though just how remains a subject of hot debate. Much academic work suggests that markets tend to go down when volatility goes sharply up, and vice versa. It doesn’t always work that way, though: during much of the 1990s, for example, both volatility and stockmarkets rose.
But higher volatility definitely favours certain kinds of investors: it gives a fair wind to those who target volatility as a strategy, and it offers more opportunities to those who hedge their bets in other grand investment designs. (So why did hedge funds have such a terrible October, by all accounts? Could it be that most of them weren’t actually hedged?)
More broadly, expected volatility has a lot to do with how attractive financial assets are. It is the main parameter in pricing options, so it determines the cost of insuring against uncertain outcomes.
When options are cheap, investors are happier to take the plunge in financial markets. When they are expensive—ie, when it costs more to hedge a bet—investors think twice. They tend to commit less capital to “risky” investment and for shorter periods.
So volatility has a bearing on economic growth, and rising uncertainty is not good news for future output. It may seem strange to worry about this now, when America’s third-quarter GDP figures have just come in stronger than expected, Britain’s housing meltdown seems to be on hold and Europe’s company bosses are raiding their cash hoards to acquire other businesses. But there are big question marks ahead. It is no accident that the VIX, often called the “fear gauge”, is rising. In October, State Street’s investor-confidence index hit its lowest since its launch two years ago.
Volatility was uncannily low until recently in large part because inflation and interest rates were too. A tide of liquidity swept through financial markets, exploiting anomalies, arbitraging opportunities and dampening volatility. Long investors saw little need to buy options against the chance that things might take a nasty turn in this best of all possible worlds, while others were all too happy to make a buck selling them. There was plenty of supply and not all that much demand, so the VIX snoozed in the teens.
Defter monetary management also played a role. Investors got used to trusting central banks to keep the financial-market show on the road, as they showed they could and would after the failure of Long-Term Capital Management, a big hedge fund, in 1998 and the bursting of the stockmarket bubble in 2000-01. And the Fed’s new policy of giving forward-looking statements on interest rates also soothed the markets: since August 2003, the expected volatility of Treasury notes has fallen by a third, on one measure.
Goodbye to all that
But low inflation, low interest rates and untroubled confidence in safe hands at the helm are fast becoming things of the past. Oil-price hikes have helped to push up inflation around the world. The Fed raised short-term rates again on Tuesday, to 4%—its 12th quarter-point hike since the middle of last year—and looks likely to do so at least once more in the next three months. The European Central Bank may soon follow its tough talk on inflation with some tough action. Japan is more likely to raise rates than to cut them.
Alex Ypsilanti, a strategist at Merrill Lynch, points out that over the past ten years the troughs in volatility have come one-and-a-half to two years after the low points in three-month dollar LIBOR (interbank) rates. The Fed started raising rates 16 months ago.
Add to this equation a new Fed chairman, especially one who may tighten just that bit too much in order to live down a reputation of being soft on inflation, and increased volatility looks virtually assured. Indeed, it could scarcely be otherwise. Looking into previous Fed handovers, Goldman Sachs found that financial markets were more unsettled in the first year than in almost all the rest of the new chairman’s time in office.
And finally, while the outlook is not all bleak—far from it—there are risks out there that neither central bankers nor financial markets nor politicians know how to handle yet. These include huge global trade imbalances and the shift in the balance of economic power that these imply; the rapid proliferation of financial instruments (mainly credit derivatives) whose valuation and ownership are not always clear; and the rising indebtedness of households, particularly in America and Britain.
Given all that, it is hardly surprising that volatility is stirring again. What is amazing is that it’s not racing down the road and barking.
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If I were a betting man, perhaps I would be looking at the currency markets. The Euro is sure to fall against the USD. Especially with political turmoil in Germany with huge financial problems. France is for Frogs. Unemployment is going to soar in Froggie Land. But what do I know, anyway? Just a geezer living in the state most like France on the left coast.
Unfornately my charting service, stockcharts.com seems to be down but my bet is that the VIX started going up in October. I don't know why but Oct is the worst month of the year for stocks. So there might be a halo effect in here to some degree but the VIX has been "complacent" for a long time and volatility at this point would seem likely for whatever reasons. Your "currency" trading idea would probably be where the most money could be made but since I don't know them I won't play them. I stick to what I know better, daytrading and short term (like 2 days) trading.
The Chicago Board Options Exchange’s Volatility Index (VIX) is based on a basket of widely traded options on the S&P 500. The more turbulence investors expect in the underlying shares, the more they are prepared to pay for options. The VIX is nowhere near the 45 that it hit in August of 2002 but, as the chart shows, it has been slowly rising since mid-July. Germany’s VDAX, an options contract on the DAX index’s 30 companies, has been trending higher too.
I love volatility. I dollar-cost average right through it, which is about the only intelligent long-term strategy in the stock market.
Though the VIX is going up it is still in complacency.
Do you ever sell a portion into strength? I did that with some gold stocks this past summer and did very well with it. I did end up selling all because gold/silver stocks seem to have no direction at all despite all the ads saying gold is going to the 700's. Of course they don't say when!
"into long bonds. (Learn More?)" ....Bill Gross! Is that you?
Why do you hate America? /s
Y'know, they've been saying the same thing about every year. 1900. Anything can happen. 1901. Anything can happen. 1902. Anything can happen...
It's true. Anything can happen. It could go way down, it could go way up. I'm going to make sure I'm in for the long run, because in the long run, it's going way up.
You're mistaken about one thing. I am as old school, buy-and-hold as they get. And volatility doesn't hurt me in the least. For three main reasons:
1. I have a long term time horizon (45 years).
2. I dollar cost average, which means I buy lots of shares of great companies when they're on sale. I love sales.
3. I have a broadly diversified portfolio. I'm not trying to play individual stocks or individual sectors. I'm not smart enough to do that (or dumb enough). I have large cap growth, lots of large cap value, mid, small, international, and bonds. I am well positioned for whatever the market decides to do. And if it tanks, I'll gladly add more.
1) Oil prices settle into a trading range centered at $60 as increased production and slower demand growth settle down the overheated oil market.
2) Gasoline prices continue to fall on reducd demand growth and small incremental expansions of existing refineries through "debottlenecking" upgrades. (For example, Marathon just completed a 35% expansion of its Detroit refinery, and I would bet that smaller upgrades were completed while refineries were repaired after hurricane damage.)
3) Natural gas prices collapse back down to $7-8 late in the winter as offshore gas platforms return to full production and inventory numbers show that production rates were boosted on some onshore wells because of the high prices.
4) Energy inflation reverses to deflation rather than the current inflation in the first half of 2006. Core inflation, not counting energy and food prices, stays around the current 1.2%. As a result of the inflation statistics and some slowing in the economy, the Fed signals that it is finished raising interest rates for the foresseable future.
5) The bond market has a huge rally and the 10-year treasury bond yield drops back to 4.3%, mortgage rates decline, the stock market also has a powerful rally, Bush's approval numbers rebound, and real estate prices stabilize around 5-15% below their 2005 highs (depending on regional location.)
The stock market seems to be just starting to anticipate this scenario as stocks of banks and home builders started rebounding and rising last week. I'm looking to buy a lot of REIT funds, bond funds, and stocks over the next few months if this scenario plays out as I expect. If not, we'll have to wait a few more months for this scenario to happen in the late spring and summer of 2006. But I really believe energy inflation will be right around zero for the full year of 2006, and that is good news for stocks, bonds, and real estate.
On currencies, maybe for a while... We can't prop the dollar up through rate hikes and media ruses (Bloomberg, for example) for very long.
5 reasons the Fed will fumble in 2006
http://moneycentral.msn.com/content/P131828.asp
But on the other hand, if an investor can guess as to how long,... As far as I know, the dollar will equalize with foreign currencies, eventually, if we continue to expand more on foreign investments and manufacturing. Buyers of goods on the retail market will be needed. And the politicos of protectionism are looming.
Or is there some way to sustain more of an import economy indefinitely without equalization (somewhat) of the dollar to foreign currencies?
I think we're close to the top in interest rates and some people in the stock market are beginning to anticipate that top. Bank stocks have been surprisingly strong over the last two weeks considering the rise in interest rates, which makes me think that some big money managers expect an end to Fed rate hikes fairly soon.
Thank you for the analysis. ...much to consider there. The study of macro-economics is interesting to me in the context of history studies and current international situations (tactical/security, for example).
Consumer confidence has recently dipped slightly, but may now be on the rebound with falling energy prices. So far, the risk premium doesn't seem to have shifted to favor bonds from stocks. My big worry is, as the article states, high debt ratios. Don't think we're near any tipping points yet, though.
I plan to stay the course a bit longer, although I have put a few more bets on laddered bonds - I don't think the Fed will raise too much further.
Dow Jones US Banking Index made a low for 2005 on 10/13/05 and has rallied 6.8% from this low to last Friday's close.
Dow Jones US Home Construction index made a medium-term low on 10/19/05 and has rallied 11.9% from this low to last Friday's close.
To some extent these reversal rallies are just technical bounces from oversold levels, but it still surprised me that these indices bounced that much while the treasury bond market was getting hammered over the last two weeks. It looks like some money managers are starting to anticipate a top in interest rates and a rebound in financial and housing stocks.
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