February 24th, 2012
Nick Hays
Dhaka, Bangladesh
Dhaka, Bangladesh
Today - on The Long and the Short:
* Market sweet spot or sugar rush rally?
* The VIX - is the market underpricing risk?
* Forever blowing bubbles
Markets in the Sweet Spot?
The last two months have seen markets stage a powerful rally. Markets for risk assets have been buoyed by the convergence of three key factors: improved US economic data, reduced probability of a ‘disorderly’ default in the Eurozone and continued injections of massive amounts of liquidity by central banks.
The ECB, BoE and BoJ have all participated in recent bouts of liquidity since December 2011:
· ECB - €489 billion LTRO programme (December 2011)
· BoE - £50bn quantitative easing, or “QE3” (February 2012)
· BoJ - ¥10 trillion (US$129bn) (February 2012)
Future sources of additional central bank ‘pump priming’ will come in the form of the ECB’s second LTRO this week, which is expected to be worth an additional €500-750 billion according to Standard Chartered; the Fed is also widely anticipated to launch its own version of “QE3” later this year. Furthermore the Fed’s recent commitment to low interest rates through to 2014 has been another prop to risk assets.
It's a potent mixture. The result? Major equity indices are now up 20% or more since October. Yields on the sovereign debt of ‘peripheral’ European economies such as Portugal and Italy are down sharply since late January. In summary the risk-on rally has been very much back in play (see charts below).
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S&P 500 index – 6 month chart (click to enlarge)
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(The red arrow I’ve added highlights declining trading volume, demonstrating that the rally lacks broad market participation. For some this is an indicator that the rally lacks ‘conviction’. A major driver of this is in fact that average retail investors have been largely sitting on the sidelines and have missed the recent gains. Incidentally, a rush of retail investors to the market is a popular contrarian indicator. The AAII's Sentiment Survey can provide clues)
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Italian Government 10yr Bonds
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Portugese Government 10yr Bonds
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How much longer can we expect to remain in the market “sweet spot”?
Continued cheap money courtesy of central banks and the simultaneous improvement in the economic outlook surely will not continue in parallel indefinitely. One of these factors seems likely to reverse: either the economic data continue to improve and central banks reign in the easy money, or the data worsen. Either one of these events will result in the market losing a major prop to current prices.
For now, however, markets seem to be having their cake and eating it too. Are we approaching a come down after the sugar rush rally?
To help answer that question, one indicator I’m watching closely is the VIX, aka the ‘Fear Index’.
The Fear Index…and what it’s telling us
The VIX is a measure of volatility as implied by the price of options contracts for the S&P 500 index - essentially this is the cost to insure against large moves in future market prices. The VIX tends to spike during times of market volatility as investors seek to hedge positions, and drops during periods of relative calm. For this reason it is commonly known as the ‘Fear Index’.
Below is a 5 year chart of the VIX:
And here’s the VIX going back to 1990:
As you can see from the above charts, the VIX has dropped more than 50% since October 2011. Looking longer term, the VIX’s Friday close of 17.31 is below the average closing price from 1990-2012 of 20.56. (Excluding the period since the onset of the financial crisis, the average price from 1990-2007 was 18.97).
This tells us that the market is pricing in a relatively low probability of future volatility. While this may be a rational response to the current ‘sweet spot’ conditions described above, I believe that the market is betting on an overly benign outlook and there is a considerably fatter “tail risk” than is currently being priced in.
Fat tails and known unknowns…
A number of economic and geopolitical risks exist, each of which is capable of delivering a sharp dose of reality to the markets.
1. Good news is bad news – continued improvement in US economic data would reduce the probability of the Fed launching another round of money printing (QE3). An uptick in inflation would likely have a similar effect.
2. Europe not out of the woods yet - History suggests that the Greece bail-out announced last week is not the last we’ll hear on the Euro zone crisis. The recent Greece deal was met with little enthusiasm by the markets and analysts are already questioning the viability of the recent deal, including the IMF whose assessment is that the balance of risks is “mostly tilted to the downside”. Furthermore, the hard line being taken by Draghi and the ECB (i.e. the focus on austerity measures to achieve debt reduction) risks exacerbating the current slump in European output. The IMF’s view is that the current stance risks sending Greece’s debt “on an ever-increasing trajectory”.
3. China hard landing - efforts to cool an overheated economy in 2010/2011 appear to be taking effect, in particular dampening activity in the real estate sector. Preliminary March data from HSBC’s Purchasing Managers Index indicates declining activity for the 4th straight month. The risk remains that China will fail to engineer a ‘soft landing’.
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| HSBC China PMI |
Forever blowing bubbles
Is risk underpriced and are assets overinflated? That depends on your perspective. Examining the fundamentals alone, the answer may be yes. Among the signals that prices are a little rich at these levels, the Cyclically Adjusted PE ratio (CAPE) is now above the long-run average, and US corporate profit margins are showing signs of having peaked.
It seems that markets are increasingly reflections of central bank policy, rather than the long term underlying fundamentals. As PIMCO’s Mohamed El-Erian puts it:
Unusual policy activism on the part of central banks...has inserted multiple wedges between valuations and the underlying fundamentals. It has also altered liquidity conditions and affected the functioning of certain markets.
Are central banks in the process of blowing yet another asset price bubble?
That may be so, but it may also be unwise to bet against the current tidal wave of cheap money. In the words of Warren Buffett , markets can remain irrational for longer than you can remain solvent. In other words, ‘don’t fight the Fed’.
Furthermore, can we even argue that the current market is pricing ‘irrationally’? To an extent, the market today is merely a rational response to two powerful trends: socialisation of risk by governments and loose monetary policy. These trends have been in place at least since the bursting of the dot com bubble, but have accelerated since the onset of the GFC in 2008.
For all the talk of ‘no more bailouts’ and breaking up the ‘too big to fail’ banks, banks are now larger and more concentrated than ever. The climate of moral hazard is alive and well and we must be alert to the effect on investment behaviour that this has.
The takeaway?
Markets may well be exhibiting some signs of ‘irrational exuberance’ in the short term and it may therefore be wise to tread carefully before committing any new funds to risk assets. My expectation is that lower equity prices will materialise in the near future.
However any correction which does come may be short lived. The current climate of easy monetary policy means that investors may need to accept a ‘decoupling’ of asset prices from fundamentals for some time ahead.
In the meantime, I will be keeping an eye on the VIX as a possible hedge against future volatility.
Constructive comments and feedback are very welcome below, or else you can contact me at nicholashays1@gmail.com
