Tuesday, March 08, 2005

Low Volatility Pointing To Some "big Moves" In Investment Markets!

Dr Marc Faber
Many commentators have recently pointed out that volatility in both the bond and stock markets around the world has been unusually low and that from the current low levels of volatility big market moves will emerge. Financial pundits also expect these moves in the financial markets to be likely on the downside. And while I tend to agree that volatility will sooner or later rise, an increase in volatility does by itself not necessarily imply that rising volatility will lead to market sell-offs. As an example, extremely low volatility in the bond market gave, in early 1987, way to a sharp sell off in bond prices and a rise in long term bond yields from 7.14% to 10.23% (bond prices bottomed out a week before the October 19th stock market crash). Conversely, low volatility in April 1998, was followed by a sharp rise in bond prices. 10-year government bond yields fell from 7.11% to 4.11% and bottomed out, in September 1998, in the wake of the LTCM crisis. So, all low volatility is suggesting is that a "big move" is coming but it does not convey the direction of the next big move. Now, in the case of the stock markets around the world we have record low volatility (see figure 1) and in the case of the US, the VIX volatility index is hovering near a ten years¡¦ low. In fact, as can be seen from figure 1, world equity implied volatility is at present far below the average volatility of the last 10 years. So, all we can say is that within the next few months a large stock market move can be expected, either up or down.

Figure 1: World Equity Implied Volatility

Source: Bridgewater Associates

But the question is obviously whether an upward or downward move in stock and bond markets is more likely. For equities, most indicators do seem to suggest that the next big move will be on the downside. Financial institutions have a record low level of cash hence there is little buying power left. Insiders continue to sell heavily. The public and fund managers are very bullish about the prospects of equities ¡V a contrary indicator, which would rather point to a sell-off in equities. Moreover, global liquidity has been tightening. Earlier in the year, I showed that money supply growth had been decelerating. My friends at Gavekal Research compile a global monetary indicator (see figure 2) that suggests tighter global liquidity, which is usually not very favorable for investment markets.

Figure 2: Gavekal Monetary Indicator, 1991-2005

Source: Gavekal Research

In the eyes of the American Federal Reserve the US economy appears to be sound (it is not) and, therefore, the Fed is likely to continue to raise short term interest rates ¡V that is unless the US economy weakens suddenly once again badly. Therefore, we should assume higher short term interest rates and tighter liquidity for the foreseeable future, which should not be good for equities.

Admittedly, the S&P made a new recovery high in the first week of March, but strength was concentrated in energy and basic material stocks while financial shares are underperforming. Usually, when financial stocks are under-performing while oils are strong the market is in the last stage of a bull market. In addition, stock markets appear - after their recent renewed strength - to be overbought. This would especially apply to emerging markets, some of which had almost vertical upward moves. At the same time corporate bond spreads are at record lows, suggesting widespread complacency about risk. So all in all, as far as stock markets are concerned it is more likely that rising volatility will give way to possibly severe market downward moves.

For bonds the picture is murkier, since bullish sentiment on bonds is rather leaning on the bearish side. Still, bonds would seem to be vulnerable as either economic growth could surprise on the upside or as "visible" inflation accelerates. By "visible inflation" I mean inflation that would show up not only in asset markets like housing, equities, art, and commodities but would manifest itself in sharply higher CPI figures, which are at present kept through statistical anomalies artificially low. Therefore, I lean toward the view that the next "big move" in bond prices, given the risk of higher inflation and higher short term rates will rather be toward the downside. Needless to say that rising short and long term interest rates would not be favorable for the housing market.

I have pointed to the vulnerability of sub-prime lenders before. Robert Prechter recently produced a figure of a sub-prime lender index, which measures the stock market performance of several sub-prime lending companies (see figure 3)

Figure 3: EWI Sub-Prime Lender's Index

Source: Elliott Wave International

In fact, all financials including Fannie Mae, and mortgage, credit card and sub prime lenders, and providers of financial guarantee products such as Capital One Financial (COF), Countrywide Financial (CFC), Accredited Home Lenders (LEND), New Century Financial Corp (NEW), MBIA Inc (MBI), MBNA (KRB) appear to be rolling over. JP Morgan Chase (JPM) ¡V heavily exposed to derivatives - is also not performing well. As observed before, strength in oil stocks and weakness in financial stocks is usually not a particularly favorable omen for the stock market. In addition weakness in the shares of mortgage lenders is not a positive indicator for the housing industry. We are short some of the financial shares mentioned above and are looking to renter the homebuilders from the short side on any sign of weakness (see figure 4).

Figure 4: Parabolic Rise of Homebuilders, 1994 - 2005

Source: Elliott Wave International

As can be seen from the above figure, the S&P Homebuilding Index has risen ten-fold since 2000 and seems to be getting extremely overextended. This particularly in view of the weakness in financial stocks I highlighted above.

What about industrial commodities? From figure 5, we can see that there is a close correlation between Foreign Official Dollar Reserves (FODOR) and Crude Oil Demand (the same correlation exists between Foreign Official Dollar Reserves and industrial commodity prices).

Figure 5: Foreign Official Dollar Reserves & Crude Oil Demand

Source: www.yardeni.com

As can be seen from figure 5, FODOR growth has been decelerating, which confirms the tighter liquidity argument I made above. And since there is a close correlation between oil demand and industrial commodity prices, I would expect under normal conditions oil and other commodity prices to ease in the near future. I am saying under "normal conditions" because oil prices could rise much further if geopolitical tensions increase. In particular, US air strikes on Iran and Syria have become a distinct possibility and could lead to soaring prices. I also admit that copper prices have recently broken out on the upside from their yearly trading range. However, the breakout is not very convincing and might turn out to be a false breakout move. As an aside, I may also add that when FODOR growth slows down, the US dollar tends to strengthen. So, whereas I remain wary of industrial commodity prices I maintain my positive stance toward the grains, about which we wrote a month ago.

Wheat, corn and soybeans have all strengthened recently and we would use any weakness as a buying opportunity (see figure 6)

Figure 6: Soft Commodity Prices

Source: Gavekal Research

I have mentioned before that since October 2003 all asset markets including equities, bonds, art, commodities and real estate have inflated in concert. At the same time volatility and bond spreads have been coming down to almost unprecedented lows while sentiment among investors is either very bullish or at least extremely complacent. This would suggest to me that risks have been rising and that the next "big move" in asset markets could be to the downside.

Finally, we should not forget that January was a down month for the stock market in the US, which is usually quite a reliable indicator for the market¡¦s direction during the year. So, while I am not ruling out some more upside potential for the US stock market until mid April, limited upside potential could give way, at any time, to a sharp increase in downside volatility. Thus, the high risks in buying US stocks and other extended asset markets (real estate in the US, and industrial commodities) at this point would, in my opinion, hardly justify the very limited near term upside potential that might still exist in the asset markets.


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