What have we learned in the past year?
Maybe not so much.
Reprise to the November 2010 post – Bottom Pickers Get Stinky Fingers
Market volatility seems to have increased...... or not.
A lot has happened this year that lead to uncertainty.
We do know that
1) the US credit rating has been lowered and Treasury bonds rallied!
2) Muni defaults can be HUGE (Jefferson County Alabama - $3 BILLION which was about equal to all the muni defaults in 2010/ Harrisburg, Pennsylvania - $300+ million / Central Falls, Rhode Island - $21 million )
Why the S&P return gets two decimal points is beyond me but notice that it underperformed bonds by more than 800 bps. These are the lowly investments that yield less than Microsoft stock at 3.00%.
3) Italy and Greece have more in common than a Mediterranean coast line
4) A lot of people are wishing John Corzine stuck to politics
5) The VIX – the point of this writing
As these five things occurred, domestically, our economy stayed in neutral with the motor on a slow idle. Unemployment stayed at 10.0% while Claims ebbed and flowed around 400,000. Productivity gained and the developed markets continue to make their best efforts to look like the emerging markets while the emerging markets did the reverse.
In other words not much happened in the past 12 months.
Lets look at the issues related
1) Credit rating – is this such a shock – really? The US Federal Reserve prints money to buy the bonds that the US Treasury issues. Well at least the bills get paid, except by the Post Office. Another matter entirely.
2) Andrea Riquier and Michael McDonald of Bloomberg wrote on November 11, 2011, that, “Returns on municipals including interest exceeded Treasuries this year through yesterday at 8.9 percent versus 8.6 percent, according to Merrill Lynch Bank of America indexes. They’ve also beaten the 0.33 percent total return for the S&P 500 equity index through yesterday, according to data compiled by Bloomberg.”
The big issues of the muni filings are not who or much but why?
Central Falls filing is telling. A small town of 19,000 people with a $17 million annual budget. However, it has a $80 million unfunded pension liability to 141 people! Now Mr. Wizard how do you stretch $17 million to pay your bills, etc and fill a gat that is 4.7 times income? This is a concern because first Great Falls then all falls…….
Unfunded pension liabilities are an issue where ever you look – what to do? One word – INFLATION. This will really hurt bind yields. Inflation is at hand and you see it every time you go to the grocery. Grapes are 50% more expensive than last year, as is meat. Large bottle soft drinks were on sale last year for 99¢ and this year for $1.25. The cost of a turkey is said to be up 20% from last year. Productivity gains have offset some inflation however, the appearance of inflation is only a matter of when not if.
3) Mediterranean vacations should get cheaper. OK, so these two historic pillars of financial stability in Europe are having problems. Not so and no surprise. Italy has had issues with monetary and fiscal policies. So has Greece. The current problems have been long in coming and the euro served to prolong the crisis. Both have viable economies and both will survive. Perhaps they were not necessarily the developed economies we were led to believe. Each has a history of survival and I would bet on either one of them to revive and fall again in the next twenty to thirty years.
4) Goldman raises the bar again. It used to be Nobel Prize winners and a guy from Solomon to sink a high flying firm. The challenge was given and a Goldman exec became an overachiever. Long Term Capital Management lost $3.7 billion while MF Global losses remain unknown. MF Global losses are unknown and with a little creative accounting and a bond rally will be nothing more than a blip. This does not appear to be a Lehman, Madoff or LTCM.
5) The VIX
It seems that the stock markets have been volatile. However, most of the movement seems to be static around the middle. Up or down the moves are big but not sustained. For the most part the markets have gone nowhere. We have been waiting for the VIX to give us a bonus. This was until we realized it had.
We get fooled by the headlines too. The New Normal is the oxymoron that best describes this behavior. Every so often a new paradigm is proclaimed. Today it is in vogue to proclaim, the New Normal. Nothing is so new or earth shattering as described above. Muni’s fail and truth be told failures are down on a number of factors. Normalize the data and it is not so bad. Countries that follow bad policies falter. Sometimes it is the same countries over and over and over again. What is amazing is that the cycle does not break. Failures occur and again it is the size and scope. The VIX is well above 20, sell volatility.
We have been waiting for bigger numbers for the VIX. We like selling in the mid 40’s. However, the index has not gotten there in the past few months even with all the drama that has happened. We asked ourselves why and did some analysis to feel better.
The S&P 500 at 1240 is basically where it began the year. And up about 100 points in the past 12 months.
The VIX at 31 is up from 18 at the beginning of the year and 22 a year ago.
So it does appear that there is forward risk priced into the markets as represented by the volatility index.
Next we charted the S&P to the VIX – after all analysts like charts and they give us something to look at and ponder.
Ponder the chart we did – and we noticed a few things that seemed curious. Note that this is a long term chart going back to 1990. Overlaid the negative correlation expected is evident. So the next question became the extent of the correlation. Had the numbers reached extremes.
The above chart gives rolling 1 year correlation. As indicated, we are currently not in an extreme area. Not so telling but merely interesting.
So we did what all curious analysts do, we tortured the date to give us something closer to what we wanted to see. Remember lies, dammed lies and statistics. The result was the ~30 day rolling chart above.
What we see is a value of -0.82 verses a median of -0.77 and an average of -0.65.
If we look at a rolling 7 day correlation the current value is -0.98 verses a median of -0.84 and an average of -0.67.
In the end the result is that the VIX is pricing risk.
Summarizing, there are a lot of things going on in the markets and the world. Although we had expected outrageous deviations on the value of VIX, it is there. The fact that the VIX has been priced at the outside ranges of “normal” only means that it belongs there as the markets are pricing risk. We must look at the pricing as it is and react accordingly. A value in the 30’s is high and recognizes that risk pricing is alive and well. The fact that it is not at the absolute extremes but has been at these high levels for a while means that the market has had its eyes wide open recognizing the presence of risk. There is no new normal, just continued high pricing of risk in an environment with a lot of risk that one can try to believe and justify as normal rather than the aberration it is.
As for our updates, we have limited our updates due to time constraints. Overall we have not increased our database and continue to keep to the same names and short date writing.
We will update within the next week or so most likely just after expri.
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