VIX Spikes and Easy Money: Volatility Dependent Fed Policy

“For all of us, the appropriate policy decision is going to be data dependent and all of us will be looking at the incoming data and our opinions about the appropriate timing of normalization are likely to shift as we look at how the data evolves.” – Janet Yellen, June 2015 FOMC Press Conference

“Data Dependent”

Janet Yellen and the Fed want you to know: they are “data dependent.” They aren’t just flying by the seat of their pants; they have a process by which they make monetary policy decisions. What that process is exactly is anyone’s guess, but “looking at the incoming data” seems to be a part of it.

Fair enough. The Fed has never been particularly good at making forward-looking assessments of the economy, so the best they can do is look at the recent past and project that into the future.

When the data weakens, they ease. When the data improves, they tighten. Or at least that’s how it used to work before the current cycle.

The Federal Funds rate was moved to 0% in December 2008 during the worst recession since the Great Depression. The U.S. economy entered an expansion in June 2009 and while it certainly has been below average in terms of the growth rate, we’ve come a long way since that point in time.

If we focus only on the economic data, there’s almost no justification for the Fed Funds rate to remain at 0%, the same level where it stood in the depths of the financial crisis when the Unemployment Rate stood at 10%. We can argue over whether it should be 1%, 2% or higher, but 0% does not seem rational given the “data.”

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Stock Market Tail Wags Fed Dog

If the Fed isn’t focusing on economic data, what exactly are they “looking at?” It is becoming increasingly obvious that when they say they are “data dependent” what they really mean is they are “S&P 500 and market volatility dependent.”

As I illustrated last December, it is the stock market tail that has been wagging the Fed dog in recent years. In 2010 and 2011 when the Fed was expected to begin “normalizing” interest rates, sharp stock market declines (17% and 21%) and spikes in volatility (above 40) derailed those plans and new rounds of easing (QE1/Twist/QE2) were initiated instead.

With the recent 12% correction in the S&P 500, similar talk has begun. Ray Dalio predicted last week that the next major Fed move will be an easing (QE4) rather than a tightening. Few market participants are expecting the Fed to follow through with plans of a rate hike in September given the recent market volatility. William Dudley (NY Fed President) confirmed this last week in saying a September hike was “less compelling” given “financial-market developments.”

Volatility Dependent

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Following the Fed playbook of the past twenty years, it would be difficult to argue that a tightening will occur in September. Historically, the Volatility Index (VIX) has crossed above 40 in the following years: 1997, 1998, 2001, 2002, 2008-09, 2010, 2011, and August 2015. The VIX was not yet created in October 1987 but we know that it certainly would have been well above 40 so we can include that as well. Following each of these prior spikes in volatility, the next Federal Reserve policy move was an easing, not a tightening (click here for our research on anticipating higher volatility using Lumber and Gold).

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We know the easing response is a reflection of market volatility and not necessarily a change in the economy because not all of these periods were recessionary. There was no recession in 1987, 1997, 1998, 2010, or 2011 and yet the Federal Reserve felt the need to act. Their goal was simple: prop the stock market back up with a flood of easy money.

September Meeting

With the VIX spike above 50 last week, will this time be different? Will the Federal Reserve finally stand their ground, raise interest rates off of 0% and not react to the short-term machinations of the stock market?

After almost seven years, we should all hope so. Why? Because 0% policy is not without costs, and is likely impeding long-term economic growth, borrowing from the future to satisfy the whims of today.

We’re far past the point where emergency easing measures are helping the real economy and I have argued over the past year that it has actually become a headwind as it 1) is a tax on savings and therefore investing, 2) is leading to a gross misallocation of resources and capital, 3) is encouraging financial engineering (buybacks/mergers) over investments in capital/labor, 4) has already created the third financial bubble in the past fifteen years, 5) is putting less money into the hands of consumers, 6) is not helping real wages as asset price inflation (and rents) outpaces income gains, and 7) has only widened the wealth gap.

To continue easing here because of stock market decline in the past two weeks risks any remaining credibility that the Federal Reserve has. It would serve as a final confirmation that the Fed is merely an instrument of the financial markets, whose sole purpose is to prop up stock prices, create new asset bubbles, and encourage ever higher debt levels.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New York

 

 

 

 

 

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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Living in the Outlier

The past few years can only be described as one of the most unusually serene periods in history for the U.S. equity market. While over time it began to feel normal, we have been living in the outlier. Let’s take a quick trip down memory lane.

The DiMaggio Streak of Markets

We’ll begin with the historic run from November 2012 through October 2014, what I have called the “DiMaggio streak of markets.” At 475 consecutive trading days above the 200-day moving average, we have never seen such a steady advance and lack of a meaningful pullback in the history of the S&P 500.

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“Buy the Dip”: The V-Bottom Formation

While the DiMaggio streak ended last October, another historic streak would continue: the V-bottom formation. Since the start of 2013, every minor pullback was followed with a vertical rally to new highs. This positive feedback loop was the most powerful we have ever seen.

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The S&P is the New 6-Month CD

In early 2015, the V-bottom formation would come to an end but another historic streak would remain intact. Word began to spread among investors that the S&P 500 was the new 6-month CD. Indeed, it had been behaving as such, up over the prior six months for an astounding 186 consecutive weeks. Only the mid to late 1990’s had a longer run.

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Out with a Bang

This streak would end two weeks ago, marking an important shift in the investing environment. It’s impossible to fully appreciate an outlier when you’re living in it. Only when the outlier ends does it become apparent.

That is where we find ourselves today, and it has ended not with a whimper but with a bang. Last week we saw the Volatility Index (VIX) spike briefly above 50, a level seen only once in the past, in the period from October 2008 through March 2009. With the greatest 5-day gain in the history of the VIX, August 2015 will always be remembered as the example of how quickly a market can move from stability to extreme volatility.

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Back to Reality

For market participants, the end of the outlier in many ways marks a transition back to reality. As I noted on CNBC last week, investing has always been about striking a balance between risk and reward. Over the past few years, there has been only reward as the U.S. equity markets were behaving like risk-less instruments. This is not how investing works; there is no such thing as risk-free reward in stocks.

Going forward, the market environment will inevitably be more challenging than the recent past. As I wrote back in March, if trees don’t grow to the sky, buy and hold returns over the next few years are likely to be well below average. In such an environment, ex-ante risk management will be increasingly important (click here and here for our CFA presentation and paper on Lumber, Gold and risk management).

Those still “swimming naked” and “dancing until the music stops” take note: we’re not living in the outlier anymore.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New York

 

 

 

 

 

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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More Risk, Less Reward: The Changing Market Environment

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One of the casualties of zero-interest rate policy has been the important balance in investing between risk and reward. After three rounds of quantitative easing and seven years of 0% interest rates, investors have been told in no uncertain terms: the streets are paved with reward; forget about risk.

With U.S. equities hovering near all-time highs, having more than tripled since March 2009, this is the primary message we are hearing from investment advisors today. There is no risk in the new investing paradigm so don’t bother worrying about it. The S&P 500, we are told, is the new 6-month CD.

And while on the surface it seems that this is true and nothing has changed, when we look underneath it is clear that something very different is going on.

More Risk, Less Reward

Over the past year, within many areas of the investable landscape, taking more risk has actually led to less reward.

In the credit markets, High Yield bonds and Senior Loans are flat since the beginning of 2014 while long-term U.S. Treasuries are up over 25%.

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Last week, High Yield credit spreads hit their widest levels in over two years.

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Distressed bonds are also reflecting a changing risk appetite, declining over 45% since last June.

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Within the equity market, High Beta stocks (SPHB) have declined 3% over the past year while Low Volatility (SPLV) names have advanced close to 14%. The ratio of High Beta to Low Volatility is at its lowest level since 2013.

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Within the currency market, Emerging Markets are trading at multi-year lows as investors are increasingly seeking out the safety of the U.S. dollar.

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When Risk Matters Again

Whether investors realize it or not, risk is starting to matter again. The Dow may be flat over the past eight months but that doesn’t mean holding a higher percentage of stocks than your risk tolerance warranted was a good decision. Just because an investment is not down does not mean it is without risk.

At Pension Partners, evaluating the balance between risk and reward is at the heart of our investment process. Currently, risk is outweighing reward with leadership in Utilities (click here for our research on Utilities) and long-duration Treasuries (click here for our research on Treasuries) suggesting an increase in volatility may be coming. As such, we have been defensively positioned since early July and will remain so as long as the risk/reward dynamic remains unfavorable.

Many U.S. equity investors believe we are sailing in calm waters here and nothing but smooth sailing lies ahead. With the Volatility Index (VIX) at 13 and years since we’ve seen a decline last more than a week, this feeling is understandable. But make no mistake about it, there’s a storm brewing just beyond the mountains. We don’t know if that storm is going to lead to another small decline as we have seen a number of times over the past few years or something larger. If nothing else, though, this storm will serve as a healthy reminder that sailing in equities is not without risk.

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

CHARLIE BILELLO, CMT

Edward M. Dempsey Pension Partners New York

 

 

 

 

 

Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.

You can follow Charlie on twitter here.

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