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For thousands of years sailors have noticed a strange phenomenon of quiet and calm waters that can occur just before some of the most violent storms. As a storm approaches, it pulls warm, moist air from the atmosphere around it, leaving a low pressure vacuum in its wake. This is the fuel that powers storms, with warm, moist air cooling and condensing storm clouds. Thereafter, this air gets pushed out of the storm clouds and descends back down to the areas of low pressure. As this air descends, it gets drier and warmer, creating a feeling of quiet and calm.
Not all storms behave this way but the ones that do can be particularly damaging, as they are preceded by a sense of complacency, leaving little time for preparation. In today’s financial market, we may be seeing the precursor to such a storm.
Over the past month, we have seen volatility rise across the investment landscape with one notable exception: a calming period in U.S. large caps. First, in the currency markets, we have seen a sharp spike in volatility, with the Dollar Index (UUP) rapidly advancing against most other currencies. In the bottom panel of the chart below, you’ll notice the rolling 30-day standard deviation (a measure of volatility) at one-year highs.
Moving on to credit, we are seeing a similar spike in volatility in Junk Bonds (JNK), whose prices are now trading at 6-month lows.
Next, within the equity space, we have seen a notable increase in Emerging Market volatility over the past month. Brazil (EWZ), for example, has suffered a decline of over 20% in September with volatility nearing one-year highs.
Which brings us to U.S. large cap equities, whose volatility is moving in the exact opposite direction. You’ll notice in the chart below that volatility not rising here but is actually nearing one-year lows.
Why is this happening when everything else is experiencing a spike in volatility? As I have been writing for much of the year (see The Fed Prisoner’s Dilemma), market participants have been rotating out of riskier areas and into U.S. large caps (as well as Treasuries and Defensive Sectors) ahead of the end of QE in October. They have been viewing U.S. large caps as the new “money market” because of the smoothness of its record-breaking advance since the end of 2012.
If you have been an investor since before 2013, though, you may question the idea that U.S. equities are without risk. Risk is still there even if you haven’t seen it in quite some time. On that point, while large cap equities in the U.S. have held up very well thus far in 2014, the average U.S. stock has not. The average stock in the Russell 3000 is actually down close to 2% this year through the first three quarters.
As we enter October, the air is warm and the waters are calm. There are no storm clouds in plain sight for U.S. equities. But make no mistake about it, a storm is brewing just beyond the horizon, and with the end of QE3 we are likely to see a renewed appreciation for risk. The question market participants should be asking here is how prepared they are for such a storm.
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 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 two award-winning research papers in 2014 on Intermarket Analysis 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, an institutional investment research firm. Previously, Mr. Bilello held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms, giving him unique insights into portfolio construction and asset allocation.
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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