VIX Suggests Investors Don’t Believe Rally Is Sustainable

by Bill Luby

Back in 2007 and 2008 I had a shipload of posts talking about the SPX:VIX correlation, its implications for stocks and the like. I even came up with a plot that I called a “fearogram” to map how changes in the VIX relative to the SPX compared with historical norms and recently dove into the subject of VIX convexity and the movements of the VIX relative to the SPX in a June 2011 Expiring Monthly article, VIX Convexity.

I mention all this because in the recent downturn the VIX has moved much faster to the upside than the SPX has to the downside, given the historical rule of thumb that for every 1% change in the SPX the VIX moves approximately 4% in the opposite direction. For instance, from August 3 to August 8 the SPX lost 11% over the course of three trading days. During the same period the VIX more than doubled, gaining 105%, considerably more than the 44% or so one would have expected. One could argue that much of the move in the VIX over and above the anticipated 44% gain represented fear and irrationality flooding into the markets.

As I write this the S&P 500 index is up 5.2%. At the same time, the VIX is down about 11.8%, close to half of the anticipated -4x move.

So to recap, the VIX rose more than twice as fast as one would expect and is falling almost half as fast it has over the course of its history. That, in a nutshell, is the fear in the market. Another way of looking at the stubbornly high VIX is that investors do not believe the current rally is likely to be sustained, so options sellers are not marking down options prices with any sense of urgency, estimating that continued high implied volatility will persist.

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NO ORDINARY SELL-OFF

By Rohan Clarke

Watching the panic pervade our market this week I was sorely tempted to pick up a few large cap stocks that were pushing pre-tax dividend yields of ~15%. In hindsight it might have been opportune to do so. Yet, I’m of the view that we haven’t seen the full extent of this unwind.

Exhibit 1 – The downdraft has been accompanied by high volumes. It could be argued that this is capitulation by the weaker hands, but for mine we haven’t traded low enough to attract ‘value investors’ (witness Jeremy Grantham’s latest tome – S&P 950). Rather the volume selling suggests that this selloff is different relative to last year’s correction.

Note too, that momentum is still reeling from the severity of the fall. Given the damage done to confidence and level of uncertainty in the market, it is likely that we will at least revisit the recent lows. Watch to see how the MACD responds should this eventuate.

Exhibit 2 – An old favourite, the McClellan Oscillator that measures market breadth has completely broken down. Again, we’d expect to see a divergence in this indicator when investors are starting to accumulate on market weakness:

At the risk of repeating myself, the playbook we’re following is one where we take our lead from government stimulus. Negative real interest rates are not sufficient in a deleveraging market. That is why QE3 in whatever disguise is more likely than not and also why Japan, the UK and any other sovereign state with their hand still on the monetary tiller will follow suit. In the absence of fresh stimulus we’ll wait for signs that the market has exhausted it’s selling impetus before leaping into the void.

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6 FACTS ABOUT THE SECULAR BEAR MARKET

By Comstock Partners

1. Eleven years ago we experienced the strongest secular bull market in U.S. history covering the period from 1982 to 2000 (interrupted only by the 1987 crash). This secular bull market ended with the most outrageous valuations in history. In fact, the P/E and px to cash flow and every other metric you wish to use were more than double the prior peaks over the past 100 years. The NASDAQ valuations metrics were off the charts and NASDAQ hasn’t come close to this high since. All this was accompanied by extreme debt increases over the prior 20 years. This was clearly (in our humble opinion) the start of the present secular bear market which should surpass the secular bear from 1966 to 1982 by a large margin. And in fact, the market did decline sharply for the next 3 years. However, the politicians and the Fed could not handle the pain that it would take to wipe out the overvaluations and excess debt that took place during the bull market. Instead, the Fed lowered the Fed Funds rate from 6.25% to 1% and kept it there for and extended period causing a second bout of “irrational exuberance” revolving around a housing bubble and a secondary stock market bubble from 2003 to 2007.

2. Wall Street and Washington wanted to push everyone possible into a home even if they were not close to being able to afford one. Washington worked with banking institutions to get them in homes they couldn’t afford and then Wall Street packaged these loans, got AAA ratings and sold them to their clients. We discussed the insanity of these processes for the entire period and felt confident that when this bubble finally burst it would be extremely painful.

3. Although many on Wall Street believe the market is currently undervalued we disagree. The market expected the S&P 500 to earn $108 in early May of 2008 but due to the bursting of the bubble the earnings came in at $50 for operating earnings (excludes write-offs) and $15 for reported earnings (GAAP). The analysts that are using $100 this year and more next year for the S&P 500 and a P/E of 15 to magically come up with 1500 on the index are guilty of faulty reasoning. We believe we will trade at below 10 times depressed earnings which should take us down to the lows of 2009 or below. It is clear to us that there will have to be a global slowdown in the second half of this year and next. The reasoning for the slowdown is again the debt, but not just the sovereign debt, the private debt is even worse than the public debt. The total debt in this country is over $52 trillion and the public debt is around $9 trillion ($14.5 trillion if you count the debt used in funds that were raided by the government like Social Security).

4. The Household Debt (H/H) is by far the most extreme and will be the debt that will be the cause of the “double dip” in our opinion. The H/H debt was almost always about 50% of GDP and 65% of Personal Disposable Income (PDI) but started rising during the past 20 years as the consumers went on a spending binge where they bought everything they could on credit (especially homes) and even used their homes as an ATM machine. This took the debt from about $5-$6 trillion to $14.5 trillion at the peak in 2008. They are now cutting back and saving more and the debt has shrunk to about $13.5 trillion. We expect this debt to decline below $10 trillion (possibly $8 trillion) and will drive the U.S. into a “double dip” and affect the global economy as well, since the U.S. is three times the size of every other country– and consumption is 70% of our economy. The latest revisions downward in the GDP for the first half of 2011 confirm our long held belief in the “double dip.”

5. The “Tea Party” could have been good for the country, if they were elected before the consumption binge and outrageous spending by the government took place. However, now we are prisoners to all the debt accumulated during the past 20 years (especially the last 10 years) as we entered two wars without paying for them and promised the elderly much more than we could deliver. Cutting spending now that we are being strangled to death by the debt is a formula for disaster-since, if we don’t generate growth now the deficits will explode.

6. Believe it or not, Europe is in worse shape economically than the U.S., and since we sell close to one quarter or our exports to Europe, the contagion over there only makes the U.S. debt situation worse. And with Japan’s demographics, which are much worse than the U.S. ( a much more aging population), they are not any better. China will also have a very difficult time engineering a soft landing after an incredible planned economic expansion based almost completely on construction of homes and office buildings.

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Four European Nations to Curtail Short-Selling

By LOUISE STORY and STEPHEN CASTLE

A European market regulator announced Thursday night that short-selling of stocks in several countries would be temporarily banned in an effort to stop the tailspin in the markets. 

The move may put pressure on United States market regulators to ban short sales as well. American bank stocks have been volatile all week as global investors expressed concerns that problems in Europe might cross the ocean.

The European Securities and Markets Authority, a body that coordinates the European Union’s market policies, said in a statement that short sales — negative bets on stocks — would be curtailed in France, Belgium, Italy and Spain effective Friday. There is already a temporary short-sale ban in Greece and Turkey.

“Today some authorities have decided to impose or extend existing short-selling bans in their respective countries,” the authority said. “They have done so either to restrict the benefits that can be achieved from spreading false rumors or to achieve a regulatory level playing field, given the close interlinkage between some E.U. markets.”

In France, that country’s market watchdog banned short-selling or increasing short-selling positions, effective immediately, for 15 days on 11 financial institutions. They are: the April Group, Axa, BNP Paribas, CIC, CNP Assurances, Crédit Agricole, Euler Hermès, Natixis, Paris Ré, Scor and Société Générale.

Italy and Spain imposed similiar 15-day bans covering financial shares, while Belgium's was for an indefinite period, according to statements by their market regulators.

The emergency measures are raising comparisons to the financial crisis of 2008, when the United States and many other governments banned short sales on many financial stocks.

European financial regulators have been discussing a Continent-wide ban over the last few days amid fears from governments like France that the short sales were driving a panic. Financial regulators held two conference calls on Thursday to complete the declaration, according to a government official with knowledge of the talks. Britain and Germany are among the countries that did not join the ban.

In short sales, a trader sells borrowed shares in hopes that they will decline in value before he has to buy them back to close out his loan. The difference in price is his profit, or loss.

Critics say short-selling encourages speculation and pushes stock prices down, sometimes feeding on itself in a panicked market. Advocates say it provides important information about investor views on companies, and also maintains liquidity.

Financial historians warned that the bans in 2008 did not work and that such measures were often driven more by political concerns — the need to display some form of decisive action — than by proved market theories.

“The short-sale ban really smacks of desperation,” said Kenneth S. Rogoff, a professor of economics at Harvard. “That’s their plan for solving the euro debt crisis? I mean, this isn’t going to buy them much time.”

The crisis in Europe, Mr. Rogoff said, goes far beyond falling stock prices and has more to do with the state of banks there, including banks in Italy and France. He said the sovereign debt problems were an extension of the stress on the system created by the banking crisis.

The increasing number of European governments that are banning short-selling puts United States regulators in a tricky position. Investors with negative views on bank stocks who are forced to close their negative bets in Europe might shift them to American banks.

On Thursday, stocks in the United States continued their seesaw ride, surging 4 percent, buoyed by hopeful data on initial jobless claims. The cost of insurance on several United States banks like Bank of America and Citigroup has gone up this week, according to Markit, a financial data company, indicating that investors are growing more negative on these companies.

The short-selling announcement in Europe stirred some immediate criticism.

“It is a crisis of confidence, and when you do something like this, it shows a lack of confidence, which is exactly the opposite of what you want to say to the markets,” said Robert Sloan, managing partner of S3 Partners, a firm that helps hedge funds manage relationships with their brokers.

Back in 2008, European and United States officials coordinated temporary bans on shorting financial stocks.

Hedge funds, in particular, were hurt by the ban back then because it interfered with trading strategies that paired negative bets with positive ones.

It is impossible to know whether the panic of 2008 would have been worse without the ban, which protected companies like Goldman Sachs and Morgan Stanley, but general studies of short-selling have found that bans on that activity can lead to more volatility in the market and lower trading volume, according to Andrew W. Lo, a professor at the Massachusetts Institute of Technology.

Mr. Lo said that banning short-selling also removed important information about what investors thought about the financial health of companies, and suggested that the bans served mainly political purposes.

“It’s a bit like suggesting we take heart patients in the emergency room off of the heart monitor because you don’t want to make doctors and nurses anxious about the patient,” he said.

Some investors have been anticipating for months that a short-selling ban might occur and were pre-emptively getting out of their short positions, said Mr. Sloan of S3 Partners. He also said that if there were more short-sellers in the market now, the markets might be falling less than they are. That is because as markets fall, short-sellers often close their positions to cash in profits, and to do so they have to purchase shares to cash out. The markets could use these sorts of buyers now, Mr. Sloan said.

Even with the European countries’ bans on short sales of some stocks, investors who have negative opinions on companies may still find ways to bet against them in the derivatives market, if those sorts of trades remain allowed.

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Economic Expansions and Recessions

By Barry Ritholtz

Another great chart from JPM on economic cycles. Note that the Great Depression far outweighs even the Great Recession of 2007-09.

>

Source: BLS, FactSet, J.P. Morgan Asset Management.
Data reflect most recently available as of 6/30/11.

Source: JP Morgan funds

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Hit me baby one more time

by The Economist

ADDICTS always crave one more hit. With stockmarkets slumping over the past two weeks investors hoped that the Federal Reserve would unveil a third round of “quantitative easing” (QE), the creation of money to bolster asset prices, on August 9th. The second round, announced in August last year, had triggered an equity rally in late 2010.

Instead of pure heroin, investors got methadone in the form of a commitment from the Fed to keep rates at their current low levels for another two years. While Wall Street managed a late rally on the day (the Dow gained almost 430 points, or 4%), the Fed’s hit gave only a brief rush. Share prices resumed their fall on August 10th.

There was a more sustained reaction to the actions of the European Central Bank, which started buying Italian and Spanish government bonds on August 8th. Though the size of the buying programme was unknown, the effect on the bond markets was dramatic. The Spanish ten-year yield fell from more than 6% to 5% within two days.

At least the central banks are having a positive effect, however temporary. Politicians, meanwhile, have left investors with serious doubts about their ability to handle the crisis. European leaders have moved from an initial stance of denial about the seriousness of the region’s debt problems through a series of sticking-plaster solutions as the rot spread. American leaders, for their part, flirted with the prospect of a default before reaching a deal that neither helped the economy in the short term nor did enough to improve the government’s finances in the long term.

Worse still, their approach has seemed chaotic. “Investors have ended up betting on the political outcome as opposed to making decisions on the basis of the fundamentals,” says Ian Harnett of Absolute Strategy Research, a consultancy.

There has been an inevitable effect on confidence. According to The Economist/FT global business barometer, a survey of business confidence, political risk is the second-biggest concern (after the economy) for executives. Between May and July, the proportion of businesspeople expecting global conditions to improve over the next six months fell from 38.3% to 23.2%; those expecting a deterioration rose from 19% to 33.7%.

Moreover, the Fed’s low-rate commitment is a sign of its concern about the health of the economy—hardly a bullish signal for stockmarkets. By the time it had reached its high for the year on April 29th, the S&P 500 had doubled from its March 2009 low. A setback was only to be expected, especially since government-bond yields (outside the euro-zone periphery) have been falling in recent months, marking concern about the economic outlook.

Bad omens

Risk aversion has also shown up in the price of gold (see chart 1), which has hit repeated highs, and in the strength of the Swiss franc, which reached a record against the dollar on August 9th despite the efforts of the Swiss National Bank to let it weaken.

In contrast, other commodity prices have fallen by 12% since April 26th. That is a potential silver lining for developed economies, since higher raw-materials prices have acted as a tax on consumers.

Less positive was the slide in bank shares, which have underperformed the broad market this year (see chart 2). On August 8th alone, Citigroup and Bank of America fell by 16% and 20% respectively. Further declines in bank shares on August 10th took Bank of America’s fall this year to 49% amid concerns it needs more capital.

Meanwhile American money-market funds are ever less willing to buy European bank debt. In a further sign of concern, shares in Société Générale, a French bank, fell by 15% on August 10th (see article); those of Intesa Sanpaolo, an Italian bank, fell by 14%; and the cost of insuring against European bank defaults rose sharply. There has also been a modest rise in the spread between the borrowing costs of European banks and of governments, though nothing like the gap in 2008, when banks were almost frozen out of markets.

In corporate-bond markets, the spreads over government bonds paid by investment-grade and speculative borrowers reached their highest this year. They have been driven by falling government-bond yields (see chart 3) more than by rising corporate rates.

Indeed, with the Fed committed to keeping rates close to zero, Treasury-bond yields are astonishingly low by historic standards. The American government is paying just 0.9% to borrow money for five years. Those rates are eerily reminiscent of Japan, where bond yields have been at rock-bottom levels for the past decade in the face of sluggish growth.

Such rates chime with the “ice age” thesis of Albert Edwards, a Société Générale strategist who has long predicted a Japanese-style crunch for the developed world. “Unsustainable private-sector debt mountains were transferred to the public sector in 2008 to prevent the adjustment to the Depression-era reality that the debt unwind would undoubtedly have brought about,” Mr Edwards wrote in his latest research note. “Yet, those debts are as unsustainable in the hands of the public sector as they were in the private.” Mr Edwards expects ten-year Treasury-bond yields to fall to 1.5% (they are currently 2.1%) before the “ice age” is over.

If the economic slowdown continues, the Fed may have to dole out the hard stuff, in the form of more QE, later this year. But many observers think that, as with the last round, it will have only a temporary impact. “QE helped to push up equity prices but those increases were based on the hope of a vigorous economic recovery that didn’t happen,” says Stephen King, chief economist of HSBC. Eventually, the markets will have to kick the habit.

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