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Volatility is Bound to Rise

By Jim Fink on January 10, 2012

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Always that sense of foreboding. Always tension. Always exhaustion. Waiting in anticipation for the storm that you know with absolute certainty is coming.  Always that feel in the air, the electrical tension as the atmosphere begins to change. Ears attuned for the first rumble of thunder in the distance. Face turned to note the slightest change in the wind. Never knowing exactly how far away or how violent the storm to come.  

Carolyn S Matheson

Although the quotation above refers to a chronic illness and not the economy, I was struck at how perfectly it characterizes my feelings about the U.S. stock market. On the surface everything looks great – the S&P 500 has risen continuously since mid-December and has now hit a five-month high, recouping all of the loss since late July 2010. During the first five trading days of January, the S&P rose 1.8 percent, the 16th-best first five days on record going back to 1950. More importantly, in the 17 instances where the first five days of January rose by 1.8 percent or more, the stock market has always finished the year with a gain. Keep in mind that one of those years was 1987, so an ending-year gain does not mean that there can’t be a stock-market crash during the year. 

Recent U.S. economic data looks strong, whether it be employment growth or consumer credit. But most of this healthy-looking data involves coincident or lagging economic indicators. I find it fascinating to compare graphs of the Economic Cycle Research Institute’s (ECRI) three main economic indicators: lagging, coincident, and leading. The level of the lagging index is pointing up with an accelerating and positive growth rate. The level of the coincident index is pointing up with a decelerating but positive growth rate. And the level of the leading index is pointing down with a stagnant and deeply negative growth rate. In fact, the leading index has had a continuously negative growth rate ever since August 19th 2010. If you believe that ECRI has accurately isolated leading economic indicators from all the rest, the only conclusion you can reach is that an economic recession remains likely.

Besides ECRI, another economic source I look at is John Hussman who has developed his own “recession warning composite” of leading economic indicators. Hussman’s composite continues to forecast a high probability of recession, one which will “blindside” many economists:

At present, our own recession ensembles, as well as ECRI’s official views, remain firmly entrenched in the recession camp. This feels more than a little bit disconcerting, as the entire investment world appears to have the opposite view. My problem is that the data don’t support that rosy “U.S. leads the world off the recession track” scenario. Leading data leads. Lagging data lags. Weak data is weak data. To anticipate a sustained economic upturn here would require us to place greater weight on weak, lagging data than we presently place on strong leading data. It’s really that simple. If the evidence turns, we will shift our view – and frankly with some amount of relief. At present, though, we continue to expect a concerted economic downturn.

A few things come to mind that could provide the spark needed to tip the world into recession: (1) a spike in oil prices caused by a U.S. attack on Iran; (2) An Italian debt default caused by unsustainable financing costs above 7 percent; or (3) a hard landing in China, a country that future U.S. prosperity depends on. I agree with Henry Blodget who recently argued in a Yahoo! Finance video that the European debt is far from over and remains a “screaming crisis.”

Am I the only one who finds it disconcerting that hedge fund managers – typically the smartest people in the room – have been cashing out of the stock market since February 2011 and presently hold their lowest equity exposure since 2009? Also disturbing are the bearish views at PIMCO, where bond king Bill Gross expects 2012 to be a “paranormal” year of either deflation or hyperinflation. Similarly, PIMCO CEO Mohamed El-Erian sees huge “fat-tail” risk in 2012 and recommends that investors be more concerned about the return “of” their money rather than a return “on” their money.

Given all the risk that faces us in 2012, I’m amazed that the S&P 500 volatility index (Chicago Options: ^VIX) has fallen to 20.5 percent, a level not seen since July 2011. It’s like investors are in complete denial. Even if the world avoids a global crisis in 2012, the VIX is simply too low and I feel that the VIX will rise significantly sometime during the first half of 2012. There are a number of volatility ETFs available to hedge your bets — both short term and mid term — but my favorite is iPath Long Enhanced S&P 500 VIX Mid-Term Futures (NYSE: VZZB) because it offers leverage that actually works (currently 1.73 times).


 

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