Low Volatility Pointing To Some "big Moves" In Investment Markets!
by Marc Faber
March 14/04
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.
Marc Faber
www.GloomBoomDoom.com
Dr Marc Faber is editor of the Gloom Boom & Doom Report and the
author of "Tomorrows Gold".
Dr Faber is a contrarian. To be a good contrarian, you need to know what
you are contrary about. It helps to be a world class economic historian,
to have been a trader and managing director of Drexel Burnham Lambert
when the firm was the junk bond king of Wall Street, to have lived in
Hong Kong for a quarter of a century, and to have a contact book crammed
with the home numbers of many of the movers and shakers in the financial
world.
Famous for his approach to investing, Marc Faber does not run with the
bulls or bait the bears but steers his own course through the maelstrom
of international finance markets. In 1987 he warned his clients to cash
out before Black Monday on Wall Street. He made them handsome profits
by forecasting the burst in the Japanese Bubble in 1990. He correctly
predicted the collapse in US gaming stocks in 1993; and he foresaw the
Asia-Pacific financial crisis of 1997/98 and the resulting global volatility.
Books by Dr Marc Faber