Volatility Index in the Danger Zone

Stock volatility is one “force” tracked by serious investors through the VIX.  Historically, low volatility indicates investor complacency, i.e. lack of concern for downside of equity valuations.  Low volatility has often foreshadowed a market downturn.

A VIX number below 10 indicates low volatility in historical terms, a rare event.  In fact, it is been reported that in the last 28 years there has only been 11 days when the VIX was below 10.  However, two of those days occurred this week, as per the chart below.  Statistically, that is quite improbable and should offer investors concern for equity valuations going forward.

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After Brexit Vote, Markets Reach New Highs

The weeks leading up to Britain’s vote on whether to remain in European Union included cataclysmic claims by economic “experts” as to what would happen to the world economy should Britain choose to leave the EU.  In the few days after the vote to leave, the US equity markets and others dropped.  However, within days the US market came roaring back and has since hit record highs.

Did the economic experts get it wrong?  Did they purposely mislead?  The answer is possibly both.  Equities’ valuations are now more influenced by central bank action then market fundamentals.  This type of perverse relationship governing economic activity is a classic warning sign of bubble creation, which ultimately always end badly.

David Stockman is a well-respected economist from the Reagan administration who then infamously questioned Reagan’s policies.  He is written an article titled “This “Market” Discounts Nothing Except Monetary Cocaine, which is a worthy read.  His comments include:

  • “The outlook for economic growth or corporate profits haven’t improved since the market’s post-Brexit low. The market’s new highs are just another party in the casino after the latest batch of monetary cocaine — helicopter money — was passed all around.”
  • “That has been exactly the pattern of multiple rounds of QE and the unending invention of excuses to prolong ZIRP into its 90th month. The resulting rises in the stock averages, of course, were the result of fresh liquidity injections and the associated monetary high, not the discounting of new information about economics and profits.”
  • “The reality of rapidly swelling deficits even before enactment of a massive helicopter money fiscal stimulus program will scare the wits out of conservative politicians, and much of the electorate, too. And the prospect that the resulting huge issuance of Treasury bonds will be purchased directly by the Fed will only compound the fright.”
  • “In short, the market is not trading on a rebound in GDP, revenue growth or a breakout of already elevated profit margins. It’s just high on one more dose of monetary cocaine that in short order will prove to have been not even that.”

It is impossible to determine how much longer it will continue, or how high the equities bubble will go.  But like all other bull markets, this one too will end irrespective of central bank interventions.  If their actions to date have indeed created a bold, the downside will be significant, quick and come as a surprise to central bankers.

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Fed’s Yellen Primes Pump

Federal Reserve Chairperson, Janet Yellen, today announced that Fed will continue its low interest rate policy for some time into the future. Many had expected Yellen to indicate that with the improving economy, the Fed would begin a slow rise in interest rates. Yellen’s commitment of more gin in the punch bowl had an immediate effect with the Dow Jones Industrial Average, S&P 500, and the UK’s flagship FTSE 100 all hitting recordYellen highs.

Generally, rising stock markets are positive signs if the rise is based on appropriate economic fundamentals.   The lengthy drive-up of equity values are instead being driven by the Fed’s low interest rates and Quantitative Easing. This is problematic at various levels. First, should there be an economic slowdown, as there inevitably will, the Fed would have no ammo left to juice up the economy. In addition, when interest rates eventually rise, overvalued equities will show a rapid decline in value causing significant economic pain.

Perhaps the most problematic aspect of the Federal Reserve’s low interest rate policies is who benefits from them. While some on mainstream benefit as equity values rise, especially in 401(k) plans, the greatest benefit goes to the highest income brackets, the people who have the most to invest. This has led to the large increase in the income disparity in the United States. The Fed’s continuation of its policies will further increase the disparity.

Finally, the Fed’s low interest rate policies have cajoled investors into higher risk investments in search of yield. This places further upward pressure on equity values as the bubble builds and guarantees that the next downturn will be exasperated by these interventionist policies.

For many months government publish statistics has shown a significantly improving economy. In addition, by the classical definition, the recession ended years ago. These two items seem in conflict with Janet Yellen’s announcement today that the economy is still fragile. Either the government’s published figures or Yellen’s comments of earlier today relating to the economy need to be questioned.

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