Gold Wins As Financials And USD Deteriorate

Monday, June 4th, 2012

With Europe’s credit traders on vacation, volumes overall were muted today in Europe but average in the US. The lack of discipline that normally occurs when the credit boys leave the room helped lift sovereign credit in Europe and implicitly US equity futures (ES) into the open today, which marked the top for the day (back in the green after an ugly Sunday night) as dismal macro data dragged debt and and equity markets back down to overnight lows. Credit and equity moved in sync in general but across broad risk-assets, correlations were loose at best as Gold was very stable holding gains from Friday while Silver exhibited its high beta ebullience and Copper and Oil followed stock’s path down and back up. Treasuries leaked higher in yield with a steepening in the curve (though 10Y and 30Y outperformed 7Y as the Twist pivot maturity seemed most active). EUR strength was sustained from early morning in Europe with JPY weakness providing some support for stocks but it seemed both VWAP and the 200DMA were the key levels today and despite two stop-runs in the afternoon, we flushed down at the last minute (off near day’s highs – thanks to Egan-Jones’ UK downgrade news) to close red for ES (2nd day in a row below 200DMA). Financials (which are close to red for the year and about to cross below Healthcare and Staples) did not participate in the swings as much with JPM and MS worst today -3% (with the latter now 25% lower than the March 2009 market trough levels) and the other TBTFs around -1.9%. VIX oscillated rather like ES today – as usual but popped back above 26% to close marginally lower on the day. While correlations did drift today, stocks remain a little too full of hope still against overall risk markets but with UK closed again tomorrow, we may have to wait for Wednesday to see how Europe (and implicitly the rest of the world) feels.

S&P 500 e-mini futures had quite a day. Limping higher from a horrible overnight dip into the US open where heavy volume and large average trade size dominated and pushed the market lower as macro data disappointed. The leak lower progressed until Europe closed and then again we pushed higher on low volume stop-runs each time halted by heavy and large average trade size hitting the tape… the close brought the UK news and snapped ES back below VWAP.

YTD S&P 500 Sector performance… financials converging down to Unch, Staples, and Healthcare

and from the March 2009 market lows, financials’ performance is very dispersed… (MS -25% and WFC +206%)

Gold outperformed as the USD leaked back ‘down’ to resync from Friday’s moves. Treasuries are selling off a little but so are stocks as it would appear for now that Euro repatriaton from liquidating US assets is occurring and Gold is benefitting from more safety bod…

HYG remains an underperformer – holding below its intrinsic value – and we worry that this kind of weakness will leak back into real bonds and drive down an already illiquid market as today saw dealer net buying (buy-side net selling) for the first time in a while…

and the hump-shaped move in the Treasury curve was clear as 7Y underperformed 5s, 10s, and 30s…

as 5s7s10s butterfly bounces off record lows…

Charts: Bloomberg

Tags: 30y, Correlations, Drift, Ebullience, Egan Jones, Futures, Gold, Jpm, Macro Data, Maturity, Overnight Lows, Pivot, Rest Of The World, Risk Markets, Staples, Treasuries, Trough Levels, Ugly Sunday, Vix, Vwap
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Spain is A Mess, No Matter How You Slice It

Wednesday, April 11th, 2012

Spain’s spreads breaking away from other risk indicators

Guest contribution by Sober Look

As the sell-off in Spanish government bonds continued today, Spain’s spreads broke away from other global macro risk indicators. Typically Spain’s bond and CDS spreads move in tandem with risk measures such as VIX or SovX WE (MarkIT Western European index of sovereign CDS), etc. But this time around, the widening has outpaced these other measures. As an example consider the relationship between Spain’s 10yr bond spread (to Germany) and SovX WE (chart below). The red asterisk indicates the current levels.

Spain to Germany 10y Gov. spread vs. SovX WE spread (last 2 years; source: Bloomberg)

One can run the same comparison against VIX or swap spreads and get a similar result. Using Spain’s CDS spreads rather than bond spreads also shows that we are in an uncharted territory with respect to this widening. Consider for example that the last time Spain’s 10-year spread was at current levels (4.3%), VIX was around 30 (it’s 21 today) and the USD 2-year swap spread was over 50bp (31bp today) – see chart below.

Spain to Germany 10y Gov. spread vs. USD 2 year swap spread

Clearly there is plenty of room for the other risk indicators to “catch up” with Spain. But for now it stands on its own with respect to the relative amount of risk that is being priced in. More Spanish and Italian debt auctions loom and it is uncertain just how much more room the periphery banks still have to absorb the extra debt. In the mean time foreigners continue to sell.

Reuters: Spain has found itself the focal point of those concerns after relaxing budget targets earlier this year and with subsequent budget-cutting plans winning little investor support – culminating in weak demand at an auction last week.

Spanish 10-year yields jumped 22 bps on the day to a four-month high of 5.99 percent before finding resistance at the psychological 6 percent barrier – though few in the market believed that level would halt the selling.

“We’re going to see Spain develop as the story this week as hedge funds look to short it,” a London-based trader at an investment bank said.

Copyright © SoberLook.com

Tags: Bps, Budget Targets, European Index, Focal Point, Global Macro, Government Bonds, Investor Support, Mean Time, Periphery, Plenty Of Room, Reuters, Risk Indicators, Risk Measures, Spanish Government, Swap Spread, Swap Spreads, Time Spain, Uncharted Territory, Vix
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VIX Below 15 — Time to Worry?

Thursday, March 15th, 2012

Tags: Amp, Investment Group, Shading, Time Periods, Vix, Volatility Index, Warning Sign
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Silver Slumps As Risk Broadly Recovers

Tuesday, March 13th, 2012

Global risk markets and US equity futures were drifting lower together (post China trade deficit data) into this morning’s confusion in Europe but around 430ET, equities pushed higher, Treasuries rallied rapidly as we approached the US day session open and broadly speaking risk was off (in everything except stocks). Commodities dropped notably with Oil and Silver losing over 1.5% from Friday’s close before heading into the US open. The across-the-board weakness in credit and our broad risk asset proxy (CONTEXT) reversed, as if by magic, as the day-session open in the US dawned and led generally by Treasuries, which staged a 4-5bps sell-off from overnight low yields (with 2s10s30s notably rising on 30Y outperformance and 10Y underperformance), we leaked back to unchanged in ES (the e-mini S&P 500 futures contract) having traded in a very narrow range all day on low volumes (across MAR and JUN). VIX made headlines for its low levels but the steepness of the term structure should be a much bigger concern. AUD weakness spurred much of the early risk-off but accelerated stringer into the US close to maintain equities as close to green as possible. A very noisy day given very little news/event risk and the general confusion in European sovereign markets which all leaked wider. Credit and the vol term structure remain notable canaries as it appears EURJPY has become carry trade-of-the-day once again.

Credit and equity resynced into risk-on from the start of the US day session but credit (especially HY) remains notable underperformer post Greece…

It is worth perhaps noting that HYG ended very marginally in the red while SPY very marginally in the green and 4 of the 5 times this has occurred this year, SPY has underperformed the following day (and we note HYG pulled rapidly up to its VWAP at the close – suggesting some selling pressure).

Commodities showed some further divergence as Silver lost its luster today relative to the other metals (and WTI)…

Broadly speaking though the underperformance of Oil and AUDJPY kept CONTEXT weaker while the recovery in EURJPY and sell-off in Treasuries (and 2s10s30s) is what kept the spirit alive in stocks – even though volumes were abysmal…

Tags: Canaries, China Trade Deficit, Commodities, Divergence, Futures Contract, Global Risk, Little News, Luster, Metals, News Event, Outperformance, Risk Markets, Slumps, Stringer, Term Structure, Treasuries, Vix, Vwap, Wti
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A Closer Look at Volatility

Monday, March 5th, 2012

A Closer Look at Volat­il­ity
Com­bin­ing Low Beta & Cyc­lic­al Strategies

by Al­fred Lee, CFA, CMT, DMS
Vice Pres­id­ent & In­vest­ment Strategist, BMO ET­Fs & Glob­al Struc­tured In­vest­ments
BMO As­set Man­age­ment
al­fred.lee[@]bmo.com

March 2, 2012
Re­cent De­vel­op­ments:

• Equity mar­ket volat­il­ity, as in­dic­ated by the CBOE/S&P Im­plied Volat­il­ity In­dex (VIX), has stead­ily de­clined since early Oc­to­ber of 2011. More sur­pris­ingly, there have been few­er in­tra­day gaps in the trad­ing of the VIX, sug­gest­ing the VIX has been sig­ni­fic­antly less re­act­ive to neg­at­ive head­lines (Chart A). Cur­rently the VIX is trad­ing at 18.43, a fair amount be­low its long-term av­er­age of roughly 20.
• As the VIX is of­ten used to gauge the nervous­ness of in­vestors, its re­cent low read­ings in­dic­ates a nor­mal­iz­a­tion of the mar­ket. Des­pite a second round bail­out for Greece, bet­ter li­quid­ity in the Euro­zone due to the European Cent­ral Bank’s (ECB), Long-term Re­fin­an­cing Op­er­a­tion (LTRO) and its swap agree­ment with five oth­er cent­ral banks, sig­ni­fic­ant risk items re­main to sug­gest that the low level of the VIX is not jus­ti­fied. In­vestors should also keep in mind that volat­il­ity has a tend­ency to re­vert to its mean.
• Though the risk rally could very well con­tin­ue giv­en the second tranche of the LTRO, a closer look at the VIX shows that it has likely bot­tomed. Moreover, meas­ures of the VIX show that its down­side mo­mentum has abated.

Po­ten­tial In­vest­ment Op­por­tun­ity:

• Should volat­il­ity sud­denly in­crease, in­vestors may want to con­sider the BMO Low Volat­il­ity Ca­na­dian Equity ETF (ZLB), which is an ef­fi­cient way for in­vestors to ac­cess Ca­na­dian equit­ies at a lower volat­il­ity than the S&P/TSX Com­pos­ite In­dex (TSX). This ETF can be util­ized as a core po­s­i­tion, as part of an in­vestor’s long-term stra­tegic as­set al­loc­a­tion. In­vestors should also note that low beta stocks have his­tor­ic­ally out­per­formed the mar­ket over the long-term. However, since there are peri­ods when high­er beta equit­ies out­per­form the mar­ket, a more cyc­lic­al ori­ented po­s­i­tion can be tac­tic­ally com­bined with ZLB to po­ten­tially gen­er­ate al­pha in the port­fo­lio.
• Provided that the year to date rally in risk as­sets con­tin­ues and re­cent com­ments by U.S. Fed­er­al Re­serve chair­man Ben Bernanke did not spook the mar­ket, in­vestors may want to tac­tic­ally ro­tate a lim­ited por­tion of their port­fo­lio to some high­er beta areas. This week’s an­nounce­ment of an­oth­er €529.5B (US$712.8B) com­mit­ment in the second tranche of the LTRO could po­ten­tially ex­tend the re­cent rally, provid­ing a fur­ther tail wind. In­vestors that are in­ter­ested in tac­tic­ally in­creas­ing the beta in their port­fo­lio, may want to con­sider our BMO S&P/TSX Equal Weight Glob­al Base Metals In­dex ETF (ZMT).
• Since the an­nounce­ment of the first tranche of the LTRO back on Decem­ber 21, ZMT has gained 10.4% on a total re­turn basis, com­pared to the total re­turn of 8.1% of the S&P/TSX Com­pos­ite In­dex end­ing Feb­ru­ary 29, 2012 (Chart B). Fur­ther­more, cop­per in­vent­or­ies, tracked by the Lon­don Metals Ex­change (LME), re­main at more than two year lows, due to a lack of min­ing activ­ity in 2011 (Chart C). China’s re­cent move to lower its bank’s Re­serve Re­quire­ment Ra­tios (RRR) could also po­ten­tially provide fur­ther up­side mo­mentum in base met­al equit­ies. However, giv­en the many risk items re­main­ing on a macro-eco­nom­ic level, the in­creas­ing sens­it­iv­ity in the VIX and with no fur­ther stim­u­lat­ive meas­ures in place, in­vestors should also con­sider im­ple­ment­ing risk man­age­ment strategies. Trail­ing stop-loss or­ders al­low in­vestors to lim­it their down­side and risk could be fur­ther con­trolled through smal­ler al­loc­a­tions to these areas, which tend to be more sens­it­ive to po­ten­tial wan­ing in­vestor op­tim­ism.

Chart A: The “VIX” Looks to Have Bot­tomed

Source: BMO As­set Man­age­ment Inc., StockCharts.com

Chart B: ZMT has Out­per­formed the TSX Since the An­nounce­ment of LTRO

Source: BMO As­set Man­age­ment Inc., Bloomberg,

Chart C: Cop­per In­vent­or­ies Tracked by LME are at More Than Two Year Lows

Source: BMO As­set Man­age­ment Inc., Bloomberg

*All prices as of mar­ket close Feb­ru­ary 29, 2011 un­less oth­er­wise in­dic­ated.

Dis­claim­er:
Stand­ard & Poor’s® and S&P® are re­gistered trade­marks of Stand­ard & Poor’s Fin­an­cial Ser­vices LLC (“S&P”) and “TSX” is a trade­mark of Toronto Stock Ex­change. These trade­marks have been li­censed for use by BMO As­set Man­age­ment Inc. BMO S&P/TSX Equal Weight Glob­al Base Metals Hedged to CAD In­dex ET is not sponsored, en­dorsed, sold or pro­moted by S&P or Toronto Stock Ex­change, and S&P and Toronto Stock Ex­change make no rep­res­ent­a­tion, war­ranty or con­di­tion re­gard­ing the ad­vis­ab­il­ity of buy­ing, selling or hold­ing units/shares in the BMO S&P/TSX Equal Weight Glob­al Base Metals Hedged to CAD In­dex ETF.

BMO S&P/TSX Equal Weight Glob­al Base Metals In­dex ETF (ZMT), one year re­turn: 5.96% and since in­cep­tion re­turn: -23.38% (In­cep­tion date: Oc­to­ber 20, 2009).

In­form­a­tion, opin­ions and stat­ist­ic­al data con­tained in this re­port were ob­tained or de­rived from sources deemed to be re­li­able, but BMO As­set Man­age­ment Inc. does not rep­res­ent that any such in­form­a­tion, opin­ion or stat­ist­ic­al data is ac­cur­ate or com­plete and they should not be re­lied upon as such. Par­tic­u­lar in­vest­ments and/or trad­ing strategies should be eval­u­ated re­l­at­ive to each in­di­vidu­al’s cir­cum­stances. In­di­vidu­als should seek the ad­vice of pro­fes­sion­als, as ap­pro­pri­ate, re­gard­ing any par­tic­u­lar in­vest­ment.

BMO ET­Fs are man­aged and ad­min­istered by BMO As­set Man­age­ment Inc, an in­vest­ment fund and port­fo­lio man­ager and sep­ar­ate leg­al en­tity from the Bank of Montreal. The in­dic­ated rates of re­turn are the his­tor­ic­al an­nu­al com­pound total re­turns in­clud­ing changes in prices and re­in­vest­ment of all dis­tri­bu­tions and do not take in­to ac­count com­mis­sion charges or in­come taxes pay­able by any unit hold­er that would have re­duced re­turns. Com­mis­sions, man­age­ment fees and ex­penses all may be as­so­ci­ated with in­vest­ments in ex­change-traded funds. Please read the pro­spect­us be­fore in­vest­ing. The funds are not guar­an­teed, their value changes fre­quently and past per­form­ance may not be re­peated

Tags: Ated, Ates, BMO, Cboe, Cing, Closer Look, Cur Rently, Cyc, ECB, Ency, Equit, Euro Zone, Fic, Fred Lee, Glob, Ily, Ings, Ity, Man Age, Mentum, Shy Side, Strategist, Struc, Tured, Ures, Vest Ment, Vice Pres, Vix, Zlb
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Is Volatility Coming Back?

Wednesday, February 1st, 2012

Via Peter Tchir of TF Market Advisors,

VIX continues to remain low, but intraday (or intranight) volatility appears to be making a comeback.  That is volatility in the true sense of moves up and down (I’m not sure when volatility came to mean ‘stocks went down’).

Chinese PMI is supposedly one of the reasons that futures are up, yet, that seems to be a bad explanation, since futures went from an Amazon induced low of 1306, up to 1311 on the PMI news, but then drifted lower and were at 1304 by the time Europe got up and running.  It has been a relentless march higher since then as it went to 1320.  It’s not quite like last year where multiple 10 point moves were the norm, but we have had a few 0.5% moves up and down overnight already.  Yesterday we hit a high of 1315 while Europe was in charge, hit 1302 once the US data was revealed, and clawed back to 1310 for a variety of reasons (month end, amazon and psi expectations chief among them).  Again, nothing like last year?s intraday vol, but starting to provide some significant moves that will make risk management a challenge again.

Main isn’t really volatile, it just goes tighter every day.  There was a brief attempt to open it wider this morning, as some courageous (or poorly informed) traders made it 143 bid.  It has been hit like a piñata since then and got as tight 139 offered.  It is giving back a touch as the US opens (the opposite trend of last year).  It has almost gotten to the point I’m scared to answer the phone since it will be my mother asking if I’m long Main yet?  For the record, by the time she knows what the obvious trade is, it’s over.

The correlation of stocks and Euro hasn’t been as strong as it was last year, though it seems to be returning.  In any case, the intraday vol there is also picking up.

This isn’t as wild as last year, but a grind to 1.32 followed by a drop to 1.30 followed by a spike back to 1.32 isn’t exactly quiet and tame.

These moves are occurring on fairly light volume.  So as hedge funds and other asset managers get themselves positioned, volatility is increasing. Volumes remain low.  Street liquidity remains very low.  I don’t see any reason for this trend to reverse itself, and think higher levels of intraday volatility are on the way.  Is it time to buy some options to capture this?

Long or short, it looks like trading some options could make sense as some timely ‘delta’ rebalancing could be very effective and the implied volatility you are paying seems reasonable. Longer dated vol has not dropped as much as short dated vol, so another reason to look at this trade.

Tags: Amazon, Correlation, Futures, Hasn, Norm, Pmi, Point Moves, Psi, Relentless March, Risk Management, Spike, Stocks, Time Europe, True Sense, Vix, Volatility
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S&P 500 Index: Short-Term Buy Signal Confirmed

Thursday, December 1st, 2011

I am writing to you from my hotel room in New York, keeping the post short and to the point as a full day of appointments lies ahead.

Further to my post of two days ago, “U.S. equities – downtrend arrested?“, my short-term technical buy signal for the S&P 500 Index has been confirmed. The rationale is explained below.

The Shiller S&P 500 PE10 has broken the 40-day moving average on the upside.

The PE10 has broken both the 12- and 26-day exponential moving averages on the upside, while the 12-day moving average is about to cross the 26-day moving average on the upside.

The MACD of the PE10 is bottoming.

The VIX has broken the short-term support.

The MACD has crossed its nine-day moving average and signaled a buy for the PE10.

But it will be a rough ride. The VIX is likely to encounter support at 24.

The RSI of the VIX is entering oversold territory.

The PE10 has closed the gap with the VIX.

The RSI of the PE10 and VIX (inverse) has bounced from an oversold level.

Sources: I-Net Bridge; CBOE; Plexus Asset Management.

Tags: Amp, Appointments, Bridge, Cboe, Exponential Moving Averages, Gap, Hotel Room, Level Sources, Macd, Moving Average, Plexus Asset Management, Rationale, Rough Ride, Rsi, S&P 500, Shiller, Stocks, Vix
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Crisis Chartbook

Tuesday, October 11th, 2011

Everybody is asking where to now with the global financial markets. I thought it was worthwhile comparing the current behavior of the financial markets with the two recent crises, namely the great financial crisis of 2008/2009 and the minor one in 2010 when the sovereign debt crisis in the Eurozone developed.

I have charted the series starting with two months before each crisis developed and ended the series 11 months later. The respective series are as follows:

• 2008 crisis: July 2008 to July 2009
• 2010 crisis: February 2010 to February 2011
• 2011 crisis: from May 2011

CBOE S&P 500 Volatility Index

The VIX is following the same trend as in the 2008 crisis. It is likely to rise again before stabilizing.

S&P 500 Index

The trend is similar to that of the 2008 and 2010 crises but milder and in line with 2010. The Index is likely to dip again in November, with a major threat of a deep sell-off in December.

Shiller S&P 500 PE10

The declining trend follows that of the 2010 crisis and is about to stabilize. There is a major threat of a drop in December if 2008’s trend repeats itself.

MSCI Emerging Market Index

The declining trend follows that of the 2008 crisis but is milder. Further weakening is possible over the next two months.

MSCI World to Emerging Market Ratio

The trend follows that of the 2008 crisis. Emerging markets are likely to outperform mature markets in coming months.

Yield on U.S. 10-year Treasury Note

The current trend is in line with both the 2008 and 2010 crises. The yield has either bottomed or will bottom in November.

Emerging Market Yield Spread

Trend is in line with that of previous crises. The spread between emerging-market bonds and U.S. treasuries has peaked and is about to decline soon.

U.S. dollar per euro

The current trend lags that of previous crises by about a month. Dollar weakness is likely in November or December.

Yen per U.S. dollar

The current trend initially started off in line with that of previous crises but probable currency intervention prevented further strength of the yen. The stability of the yen against the dollar is likely to continue.

Emerging-market currencies

My implied emerging-market currency index is calculated by dividing the MSCI Emerging Market Index by the same Index in local currency terms. The Index was initially behind the trends of the previous cycles but caught up recently. While emerging-market currencies are likely to stabilize against the U.S. dollar there is a threat of a major weakening in November and December.

Gold price (US$/oz)

Gold’s trend is in line with that of the crisis in 2008 but stronger.

The sell-off in gold in the current crisis mirrors the sell-off during the 2008 crisis. In 2008 the sell-off coincided with the peak in volatilities in financial markets as measured by the VIX. Is gold telling us that the angst in financial markets is likely to be over soon? If so, then gold is likely to resume its upward trend.

The platinum-to-gold spread

The spread currently follows the same trend as that during the 2008 crisis. If 2008’s trend is repeated, the current spread is bottoming and likely to rise in coming months.

Silver (US$/oz)

The silver price was unmoved by the 2010 crisis. As in the case of gold the silver price initially held up well during the current crisis.

Silver also eventually succumbed to the crisis as it did during the 2008 crisis and fell heavily when volatility in financial markets rose substantially. Silver bottomed during the 2008 crisis when volatility in financial markets peaked. Is silver also telling us that the extreme volatilities are likely to subside soon? If so, then silver is about to resume its upward trend.

Gold/Silver Ratio

The ratio is following a similar trend to that during the 2008 crisis.The ratio can be expected to trend downwards over coming months. Silver is therefore expected to outperform gold.

Copper (US$/ton)

Copper is following trends similar to those during the previous crisis and especially the 2008 crisis. If the trend during the 2008 crisis is repeated, the copper price is likely to decline further in November before heading north afterwards.

Sources: Robert Shiller; CBOE; I-Net Bridge; Plexus Asset Management.

Tags: Bonds, Cboe, Crises, Debt Crisis, Dollar Weakness, Emerging Market Bonds, Emerging Markets, Eurozone, Financial Crisis, Global Financial Markets, Gold, Market Index, Market Ratio, Market Yield, Mature Markets, Shiller, Sovereign Debt, Treasuries, Vix, Volatility Index, Year Treasury Note, Yield Spread
Posted in Bonds, Brazil, Gold, Markets | Comments Off

Volatility: The Pulse of the Market

Tuesday, September 20th, 2011

The extreme volatility in U.S. equity markets and other global equity markets prompted me to analyse the current situation in comparison with history and to ascertain what causes significant changes in volatility.

The CBOE S&P 500 Volatility Index, better known as VIX, is constructed by using the implied 30-day volatilities of a wide range of S&P 500 Index put and call options. With the VIX only available from 1990 I have extended the volatility index by adding the CBOE S&P 100 Volatility Index or VXO from 1986 to 1989 to the VIX series.

The VIX is generally used as an indicator of greed/complacency or fear. I call it the pulse of the market. Any move above the average of 20.8 is a reflection of anxiety, while a move below is a reflection of calmness. The current anxiety of the market is clearly evident in the graph below.

Sources: CBOE; Plexus Asset Management.

In the graph below I indicate the average VIX since 1986 (20.8) with one standard deviation above (28.8) and one below the average (12.8). It is evident that VIX values greater than one standard deviation above the average can generally be associated with a large amount of volatility as a result of significant events – as is the case currently.

Sources: CBOE; Plexus Asset Management.

During sustained bull markets the pulse of the market is calm but moves towards neutral and anxiety towards the end of rising markets and the commencement of declining markets. It was evident in the run-up to the 1987 crash when the market went into anxiety mode nine months prior as well as at the end of 1989. In 1997 the VIX started trending towards neutral and anxiety mode three years prior to the spectacular end of the extended bull market in 2000. Anxiety persisted until the first quarter of 2003 before calmness set in. In the second quarter of 2007 the VIX started to trend to neutral and anxiety mode 12 months before the S&P 500 topped out and entered a declining trend. Although the market briefly went into a period of calmness in the first quarter of last year this was followed by brief snaps of anxiety and calmness, ending in the current state of anxiety.

Sources: CBOE; I-Net Bridge; Plexus Asset Management.

But what is the main determinant of volatility as measured by VIX? Greed and fear from my point of view as investor is not indifferent to expanded or contracted market valuation levels. I therefore used Robert Shiller’s PE10 where the price level of the S&P 500 is expressed as a ratio to the average trailing earnings of the past ten years as valuation model and compared it to VIX.

Sources: CBOE; Robert Shiller; Plexus Asset Management.

Timeline:

• The significant jump in the PE10 from 13.4 in 1986 to 18.3 in 1987 was accompanied by a significant increase in volatility and therefore anxiety as measured by VIX. The volatility only returned to neutral levels after the crash of 1987 induced by program trading when the PE10 retreated to 13.4 or to pre-blow-off levels.
• 1990 mirrored 1987’s situation with the Gulf Crisis the trigger to bring valuation levels back to levels that restored calm in the markets. In 1997 the VIX started trending towards neutral and anxiety mode as the PE10 rose.
• Although the Asian crisis in 1997 increased anxiety or volatility it had no lasting effect on the PE10. The Russian crisis of 1998 also had no lasting impact as the PE10 briefly fell from 38 times to 33.5 and rose further afterwards.
• Volatility remained at anxiety levels until the market topped out early in 2001 with a PE10 of 44.2 when the Dotcom bubble burst. The tragic 9/11 followed and corporate scandals such as Enron kept the anxiety levels high but the PE10 remained at elevated levels above 30.
• The September 2002 market crash led the PE10 to bottom in February 2003 at 21.2 – levels similar to that of 1995 when the market last experienced “calmness”. The VIX dropped significantly and the PE10 thereafter remained stable at around 26 for the next 4 years.
• In June 1997 the VIX again rose to and reached anxiety levels in July that year. As anxiety increased the market finally cracked in January 2008 as the PE10 started to fall as the subprime crisis unfolded and crashed in October as volatility increased significantly on the back of the Lehman saga and ensuing interbank collapse. Anxiety started to subside only when the PE10 dropped to a level of 13.3.
• The debt crisis in Greece in June last year saw a significant increase in volatility but the PE10 retreated moderately to 19.7 from 21.8 in April. Calmness was restored and the PE10 rose to 23.7 in May.
• Since then anxiety levels have increased as the European debt crisis deepened and a consumer confidence crisis in the U.S. developed. At the same time the PE10 dropped to 19.8, which is where we are now.

I also assessed the impact of the underlying economy on volatility or VIX. I identified two major indicators of the underlying economy in my analysis, namely consumer sentiment and my calculated GDP-weighted PMI for manufacturing and non-manufacturing combined.

Until the end of 2007 the Conference Board Consumer Sentiment Index (please note the reverse axis) and VIX maintained a narrow relationship but it broke down early in 2007. In August 2007 the Consumer Sentiment Index started to weaken when VIX entered anxiety territory and continued to weaken through March 2008. Sentiment only started to improve when the S&P 500’s volatility started to subside.

Sources: CBOE; Conference Board; Plexus Asset Management.

It is evident that high volatility is consistent with a GDP-weighted PMI below 57 (please note the reverse order of the PMI axis). From July 2006 the PMI started to falter but the VIX remained in “calmness” territory until a year later when the VIX caught up.

Sources: CBOE; ISM; Plexus Asset Management.

The relationship since July 2007 when the VIX entered anxiety level is evident in the following graph (please note the reverse order of the PMI axis). Until September 2008 the VIX reflected the underlying level of the PMI, but since then it has led the PMI by approximately one month. A major diversion is evident in March this year, though. The PMI weakened significantly from February to April but the VIX kept on declining and only started to play catch up in July. Currently the VIX is pointing to the PMI falling to 50 and below in September/October.

Sources: CBOE; ISM; Plexus Asset Management.

In summary, it is clear to me that the volatility of the equity market and that of the S&P 500 in particular as measured by VIX is influenced by valuation levels and the underlying economic trends. But what are the mechanics behind it and who is responsible for the increase in volatility?

Suffice it to argue that when the majority of investors become concerned about extended valuation levels and/or the threat of weaker economic circumstances ahead, the demand for derivatives to lock in profits and to reduce downside risk increases. The demand for, say, put options increases, resulting in higher prices of the options. The higher value investors are willing to pay for put options theoretically implies a higher value for volatility. The implied volatility of the options therefore increases and so does VIX. Therefore it can be said that investors are willing to pay more for the same option and thus are inclined to accept higher volatility.

On the other hand the writer or grantor of the option has the choice of leaving the option naked, thereby effectively going long of the market or to delta-neutral hedge the option by selling sufficient exposure of the underlying asset or the S&P 500 against the written option. The writers of put options who are bullish in a strong rising market tend to do so to collect the premium on the option to boost income.

When the S&P 500 starts to lose momentum or fall, the grantors of the options need to neutralise their positions by selling the underlying asset or buy put options as their value at risk increases. A vicious circle ensues. The price of the underlying asset (in this case the S&P 500) drops and actual volatility increases, while the implied volatility soars due to higher demand for put options. The volatility and downside of the market is often exacerbated by investment banks and other institutions who granted far out of the money put options for plain premium income considerations that all of a sudden threatens the balance sheets of the grantors. The grantors are then forced to sell indiscriminately to protect their balance sheets at all costs.

The price of the underlying asset continues to drop until it finds a level where the majority of investors become less risk averse and comfortable enough to buy the underlying asset. Demand for protective measures falls away and so does VIX as implied volatility drops.

What about the current situation? Where is the VIX heading? What are the implications for the S&P 500?

The current situation is similar to that of the middle of last year with concerns about the global economy given the debt stress in Europe, a weakening trend of the U.S. GDP-weighted ISM PMI and weakening consumer sentiment. The rating of the S&P 500 as measured by the earnings yield (inverse of PE10) is at levels similar to those in July/August last year.

Sources: CBOE; Robert Shiller; Plexus Asset Management.

The current rating is in the same region as in 2003 after which the market turned for the better and volatility dropped. It is evident that the market is extremely vulnerable to further shocks that could see a surge in volatility and a further massive derating. Barring any other unforeseen crisis that could lead to a further spurt in volatility, I believe the S&P 500 offers value at this stage. But do the majority of other investors share my view? Only time will tell, as calm needs to be restored before we will see any sustained upward momentum in the S&P 500 and other global equity markets. What is clear to me is that the market has entered a period of above-average volatility that is likely to be sustained in coming years �’ similar to that of 1997 – 2003.

Sources: CBOE; I-Net Bridge; Plexus Asset Management.

Tags: Anxiety, Bull Markets, Calmness, Cboe, Commencement, Complacency, Current Situation, Extreme Volatility, First Quarter, Global Equity Markets, Greater Than One, Greed, Nine Months, Plexus Asset Management, Second Quarter, Significant Events, Standard Deviation, Vix, Volatility Index, Vxo
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It Sure Looks Like 2008

Friday, August 19th, 2011

From Tony Pallotta of Macro Story

It Sure Looks Like 2008

“He observed that human emotions collectively had major impacts on the on stock prices and the patterns seen in the Stock Markets in general.” – From a book on the teachings of Jesse Livermore

When you think of it in the short term markets are nothing more than a group of people trying to process data and understand what others are doing all under the stress of losing personal wealth. They are trying to solve a problem that in may ways is not solvable unless one can adapt. Similar to a group of Navy SEALs on a mission. They are successful only if they can adjust to the changing situation. There’s a reason few are SEALs and few are successful in this business.

At times like these markets are more about human psychology and less about technical and or macro data. That is why I wrote about the 2007 topping pattern as compared to the market in June and July. The macro data in both instances was deteriorating yet equity markets refused to listen to falling bond yields, falling commodity prices and countless credit products. Then the recession hit, the data deteriorated fast and ill prepared markets were forced to catch up.

Now I believe it is time to fast forward to the fall of 2008. Once again the 2008 market is a road map of how human emotion reacts when credit events happen. When economic data deteriorates at an exponential pace. When the unthinkable becomes reality.

The volatility skew relative to the vix captures market sentiment very well. Overlay any such chart with the SPX and the similarities are without question. So for all those pundits who say this is not 2008 I present the following chart. Once again markets are pricing in the unthinkable. In 2008 history witnessed the failure of Lehman, AIG and the GSEs. Today history is bearing witness to sovereign nations on the brink of failure. In 2008 there was the threat of bank runs. Today there is the threat of currency runs. In 2008 there were government bailouts. Today there are central bank bailouts.

Through it all market participants have not changed. They are still a group of individuals trying to process data and understand what others are doing all while real money is on the line. As history has proven once again they will get it wrong. Once again leverage will destroy balance sheets. Denial will get in the way of rational thought. History truly does repeat and the patterns are present in the charts.

Tags: Bearing Witness, Bond Yields, Commodity Prices, Economic Data, Exponential Pace, Human Emotion, Human Emotions, Human Psychology, Jesse Livermore, Macro Data, Market Sentiment, Navy Seals, Pallotta, Personal Wealth, Sovereign Nations, Spx, Stock Markets, Stock Prices, Term Markets, Vix
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