MorningWord 8/22/14: A Game of Risk

by Dan August 22, 2014 9:50 am • Commentary

I’ll keep this short this morning.  Yesterday I wrote of how I am often confounded by macro movements in currencies commodities and bonds (In Our Own World) and their effects on the U.S. equity markets (of which I am most focused) concluding:

given the valuation spread, the fact that European stocks remain under pressure while U.S. stocks continue to rally is bizarre truth in 2014.  So while the strains in Europe from a macro perspective are obvious, the bottoms up analysis still suggests that U.S. stocks are the anomaly in the market.  But momentum is a force in and of itself, and at the moment, it’s oblivious to any and all arguments against owning U.S. stocks.

That opinion was based purely on relative valuation, and economic factors.  This morning, as we wait for Fed Chair Yellen’s speech in Jackson Hole, it would seem that we are once again focused on macro musings and their effects on U.S. stocks and Treasuries.  But what planet are we living on to think that there are potentially much larger catalysts brewing in the world at the moment than whether or not the U.S. Federal Reserve will be a tad more hawkish than some think.  It’s not exactly a surprise that after 6 years of a zero interest rate policy signal, the Fed may consider raising rates at some point in 2015, give or take a few months.

In my mind this week’s tragic execution of U.S. Journalist James Foley by the terrorists known as the Islamic State should have shaken the relative calm and complacency in U.S. equity markets as it probably guarantees an increased U.S. involvement on both sides of the Syria/Iraq border. (ISIS’s defeat at Mosul Dam most likely pushed them towards the path of execution of prisoners on YouTube)

Instead, the VIX closed below 12 at its lowest level in a month, and SPX made a new all time closing high.  And the escalation in Iraq isn’t the only thing out there right now.

Let’s take a scorecard this week: As mentioned, ISIS brought the world’s attention to themselves, virtually guaranteeing a broader cooperation between the U.S./ Europe/ Turkey / The Kurds and maybe even Syria (shhh) with the Pentagon suggesting they are a threat ‘beyond anything we’ve seen’; Russia essentially invaded Ukraine this morning; and the fragile cease-fire in Gaza broke hard. Russia has shown no signs of embarrassment (or any sign of backing off) after the downing of a commercial airliner, while the Middle East continues to burn in a way that shows little hope of flaming out anytime soon.

If ISIS sees more setbacks in Northern Iraq there’s even the chance of them attempting terrorist attacks outside of Syria and Iraq, which would turn the situation from a cross border battle into a regional or even international one.

I’m not trying to be a fear monger but ISIS, given their apparent organization, funding (especially with stolen oil revenues in Iraq) and growing support among fanatics from places as far away as East London is likely the greatest single international terrorist threat since Al Qaeda leading up to 9/11. Obviously, none of these factors have yet affected the U.S. markets in any meaningful way, and that makes sense so far. But the risk of any one of these things spiraling out of control is increased simply by the fact that there are so many candidates to spiral out of control at the same time.

Just because we have not had a meaningful 10% correction for the longest time since the mid 1990s does not mean all is well in the world – our friends in Europe just had one and the correction may not be over:

Euro Stoxx 50 (SX5E) 1yr chart from Bloomberg
Euro Stoxx 50 (SX5E) 1yr chart from Bloomberg

While many in the U.S. stock market point to the shallower and shallower dips as evidence that buyers are waiting in the weeds on each selloff, the inability of the European stock market to bounce back more strongly suggests that global investors are not quite so enthusiastic about stocks.  We noted the relative weakness in small caps yesterday as another sign that investors are getting more cautious.  Of course, all these warning signs are viewed as worthless by many as long as the S&P 500 index is making new highs.  That view has a recency bias that can be quite damaging to a portfolio, especially if geopolitical developments lead to more unexpected conflict.

If you haven’t watched Vice’s amazing series on ISIS, you should.  Their nihilism scares the crap out of me: