The index of stock market volatility (the VIX) has gone from almost nothing to quite something. Market experts are donning their Hi-Viz safety apparel. Should we be worried?
What are stock markets for?
A nineteenth century economist would have answered the question by saying that they are a means of providing essential equity finance to new businesses that promise decent returns, medium-term. A twentieth century economist would have said that they are an essential way for societies to build up long-term investment portfolios – specifically pensions. They would also, like JM Keynes, have argued that stock markets ultimately set the price of capital in the economy.
Then a clutch of late twentieth century financial economists, mostly alumni of the University of Chicago, came up with the approach generally known as the Capital Asset Pricing Model (CAPM). This came about from the work of Jack Treynor (1961, 1962), William F. Sharpe (1964), John Lintner (1965) and Jan Mossin (1966) who built on the earlier work of Harry Markowitz. Markowitz had developed modern portfolio theory in the 1950s with its emphasis on the risk-reducing effects of diversification. William F. Sharpe, Harry Markowitz, and Merton Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to financial economics.
The CAPM asserts (I simplify, inevitably) that the cost of capital is equal to the risk free rate (RFR – the return on long-term government debt) plus a risk premium – the additional return provided by the stock market (over time) above and beyond the RFR. Of course, the overall stock market return is the agglomeration of gains and losses achieved by individual stocks. Market risk is deemed to be systemic but individual stocks carry idiosyncratic risk. This idiosyncratic risk can be captured in particular values of beta – the sensitivity of a stock’s share price to a change in the value of the market as a whole. Conventionally, stocks with high betas are considered more risky than stocks with low betas.
Fischer Black (1972) developed another version of CAPM, called Black CAPM or Zero-Beta CAPM that does not assume the existence of riskless assets such as government bonds. Actually, even government bonds issued in a government’s domestic currency are not entirely riskless – so the RFR is something of a misnomer. I discussed recently in the context of Africa how sometimes governments have chosen to default on domestic debt in order to forestall a currency crisis (most recently Russia in 1998).
When I was analysing hedge funds – then new kids on the block – in the late 1990s, the RFR was deemed by the industry to be around 5 percent (this being the average yield on one-year Treasury bonds from around the time of the WWI – the Federal Reserve was founded in 1913 – to the mid-1990s). And the risk premium was usually considered, depending on whom one spoke to, as around 7 percent over the long-term.
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So, two decades ago, the cost of equity was thought to be around the 12 percent mark (5+7 percent). Any fund that consistently exceeded that level of required return was a winner. Of course, in retrospect, that process of analysis seems simplistic. But then the world, and our understanding of it, has changed dramatically since then. (For a start we have had near-zero interest rates – of which more below.)
Some contemporary commentators on the left, like Paul Mason who is now advising the Labour Party, believe that stock markets have no social utility at all. Incoming socialist governments beginning with Lenin’s in 1917 have a tendency to close stock markets down altogether. And, as I have repeatedly discussed over the last couple of years, the Marxists are well and truly back.
The stock market: casino or barometer?
Leftists have been inclined to call stock markets casinos. But even the most facile examination of stock market returns informs us that they are not a game of chance. The shares of companies that are making money – or which the market thinks will make money in the future – rise in value. The shares of those which are losing money – or which the money men believe will lose out going forward – will bomb. Of course, short-term, the markets mis-price stocks because the flow of information (and analysis of it) is imperfect. It really is as simple as that.
Is the stock market a perfect mirror image of the economy as a whole? Of course, not: it is future-oriented, and therefore it is a measure of where the market thinks the economy is headed. Just as a barometer, which detects changes in atmospheric pressure, indicates to us (with varying degrees of accuracy) the direction of the weather.
The degree of volatility – the statistical measure of day-to-day price fluctuations as measured by the Chicago Board Options Exchange Volatility Index (VIX) – has hit the roof.
Many mainstream economists emphasise the wealth effect of the stock market. The wealth effect, as articulated by Paul A Samuelson, author of a classic doorstep economic textbook, worked like this. When the stock market rises people feel wealthier. (That assumes they all own shares – but never mind.) With more consumers spending, the economy grows. That, in turn, leads to a rising stock market… So stock market bubbles tend to be self-reinforcing – feedback loops, if you will.
Certainly, a gently rising stock market engenders a feel-good effect. But, to be honest, very few people follow the stock market at all. We all know people who check the FTSE 100 and the S&P 500 every ten minutes – but these are people who have a professional interest. I try not to check the markets more than once a day because most stock market oscillation is just white noise – though the long-term trend of the major markets does matter fundamentally… The trick is to distinguish between the noise and the harmony.
What has changed?
There was no Trump Bump. That term suggests that the markets rocketed and then plateaued following President Trump’s election. Rather, there was a very smooth and steady upward inclination in the US markets which actually began well before Mr Trump’s arrival in the White House. So smooth was the ride that we got accustomed to historically abnormally low levels of volatility. That has now changed.
On Monday, 05 February the New York market suffered its most dramatic one-day fall ever (in terms of points though not percentage-wise). The S&P 500 was down by 4.1 percent. It rallied somewhat over the following two days and then on Thursday, 08 February it fell by another 3.75 percent yielding a four-day trading performance of around minus 6.7 percent. These two days are the only days on record that the Dow has plunged by more than 1,000 points.
Since then the Dow – though not the FTSE 100 – has more-or-less recovered its poise. In fact, the long-term performance of the FTSE-100 is dire: it is now only modestly above its millennium peak of 7,000 18 years ago. (What I call 18 years of going nowhere – not counting dividends, of course.) Mind you, as I have argued in these pages, the dynamism of the US market can be largely attributed to a relatively small number of high-tech stocks.
But the degree of volatility – the statistical measure of day-to-day price fluctuations as measured by the Chicago Board Options Exchange Volatility Index (VIX) – has hit the roof. The VIX aims to capture the expected level of volatility in the stock market as implied by current equity options prices. On 26 January the VIX stood at 11.08. On 05 February it hit 37.82. This morning it is at 22.47. Is there any deep-seated underlying cause for the markets getting a dose of the jitters?
Yes there is: the markets have finally awoken to the reality that interest rates are about to rise – and to rise repeatedly over time.
Cheap money is an aberration
The era of cheap money, imposed not by elected governments but by the priestly caste of central bankers who reside – quite literally – outside of the democratic state, since national parliaments (including our own) have accorded them egregious powers which are entirely unaccountable to mere electors like you and me, has fundamentally skewed the economy and financial markets.
A decade or so of unprecedented near-free money has undermined the economy’s capital-pricing mechanism – the stock market. In a zero-interest world, the RFR is zero and the required return is equal to the idiosyncratic stock risk. This has led to stocks being mis-priced: and in unnaturally low levels of volatility which have obscured that mis-pricing.
The Capital Asset Pricing Model, which business school swats (myself included) lapped up as Gospel financial truth in the three decades before the Financial Crisis, was casually deleted from the curriculum post-2007. When the politicians (like Gordon Brown in 1997) surrendered their powers over interest rates to the arrogant state-funded super-bankers who now run the world, they did not realise that they were also condemning a hitherto respected financial theory.
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They also condemned investors, great and small, to a desperate search for yield. By lowering interest rates to near-zero – so the CAPM tells us – rates of return across the economy are also enfeebled. So moderate and sober investors have to shift up the risk-return continuum in order to obtain their minimum required yield. In plain English, normally sensible people start buying rubbish.
This is particularly manifest in the innumerable investment scams that have been unleashed in the era of zero-rates: carbon credits, diamond futures, hardwood plantations, phantom shares – and it is overwhelmingly the elderly, the vulnerable and the naïve who have been fleeced – apparently quite legally in many cases.
European bourses follow the USA
Last week I asked what could possibly go wrong for European bourses. Yesterday afternoon (01 March) they were sliding: the Frankfurt DAX was down 1.8 percent while the Paris CAC-40 was down 0.9 percent. This morning Asian stocks are in retreat – a reaction to President Trump’s announcement last night of swingeing tariffs on steel and aluminium imports.
Yesterday, Jerome Powell, who has been a Fed governor since 2012 and spent almost 20 years as a partner at private equity firm the Carlyle Group, publicly outlined his views on monetary policy before the Senate for the first time since succeeding Janet Yellen on 05 February (evidently a fateful day). This was his second day out on Capitol Hill this week.
Unlike the academic tone adopted by his recent predecessors, the 65-year old private equity man chosen by Mr Trump was direct. He signalled clearly to Congress that he would tighten monetary policy against a backdrop of a strengthening economy that could be in danger of overheating.
The notion that the US central bank will be reluctant to raise rates if the equity and credit markets suffer bouts of turmoil is sometimes referred to as the Fed Put. After years in which the Fed’s actual rate rises have failed to match its projections, investors now face the prospect that 2018 may result in the central bank not just meeting its current forecast of three rate rises, but exceeding it.
Investors now face the prospect that 2018 may result in the central bank not just meeting its current forecast of three rate rises, but exceeding it.
The bout of selling across Wall Street in early February which sent the S&P 500 down more than 10 per cent — its first real correction since early 2016 — and handed US stocks their largest monthly loss in more than two years, had led some traders and money managers to expect a cautious tone from Mr Powell. Yet he told the House Financial Services Committee that the outlook for the US economy had strengthened since the Fed’s last review of rates in December, bolstered by strong economic data and tax reform.
The money markets have reacted accordingly. Three month US Dollar LIBOR yesterday went above two percent – a level not seen for almost a decade. The yield on three-month Treasury bills has also firmed. The US Dollar yield curve has also flattened in the month since the 05 February week of turbulence, with the differential between two-year and ten-year treasury spreads down to about 60 basis points – from a peak of 78 pips on 12 February.
During the week of the Wall Street Wobble, Mr Carney of the Bank of England also warned that inflationary pressures were accelerating in the UK and that rates may have to rise sooner rather than later there. Mind you, I seem to recall he said that last year – and the year before.
The first is that given share buy-backs and momentum-driven Exchange Traded Fund (ETF) investment, some share prices have been driven past even the most optimistic future earnings scenarios. There have been record inflows into ETFs over the past two years: I am tempted to say that they have become the Shadow Banking System 2.0.
Secondly, a lot of US stocks, it seems, have been bought on credit via margin-based clearing houses. Another sharp fall (say 5 percent plus) could trigger a commotion. In this respect the US markets are more exposed than Europe’s.
Third, consider that those tech-driven superstars – the FAANGs et al – have all come to maturity in this weird world of near-zero rates. What if their business models cannot cope with a normal interest rate world? What if they are obliged to charge for their products just as we pay up at Costa or at MacDonald’s? I shall suggest a possible answer to that question shortly.
Reading the runes
In simplistic financial models interest rates should be inversely correlated with stock market values because future cash flows associated with stock market investments are discounted at the opportunity cost of capital – which is sensitive to rate rises. Except that the opportunity cost of capital has been contaminated with rates of interest that do not reflect (in the Keynesian sense) the true cost of money. (That is a rate which sets savings and investments in equilibrium).
Near-zero interest rates are a state-induced phenomenon that created false markets. The creeping “normalisation” of interest rates will not necessarily precipitate a fall in stock market values. But, as the head of hedge fund Tudor Investment Corporation, Paul Tudor Jones, said earlier this week, higher volatility is inevitable. The Financial Times reported him as saying in an interview with Goldman Sachs:
Volatility collapsed after the Crisis thanks to central bank manipulation. That game’s [now] over. With inflation pressures now building we will look back on this low volatility period as a five standard deviation event that won’t be repeated.[i]
The economic fundamentals are still remarkably encouraging worldwide. Although Brexit is now entering an extremely dangerous phase which is likely to inhibit the FTSE index and blight the pound, short-term at least. (I shall have more to say about that next week). But I am still sticking with my call that the Dow will reach 30,000 this year – though there will be major turbulence along the way.
Low volatility, like low interest rates, is the unnatural and evanescent outcome of state intervention. Do not fear turbulence – rather embrace and enjoy it. There is, however, one not insignificant downside to the restoration of “normal” interest rate levels. That is that almost all western governments will inevitably go broke. I shall play with that idea shortly.