There have been no shortage of geopolitical events blamed for the 7% decline in the S&P500 (SPX) since making all time highs on September 19th. But let’s be clear – after a two year period where volatility has been artificially depressed (the two year average on the VIX has been 14.30 vs the long term average of just below 20) the why matters little. It was inevitable that volatility would return one day.
Your guess is as good as mine as to whether or not yesterday’s panic close in the SPX marked a short term bottom, or was it merely trade-able bounce that should be used to lighten up on long equity exposure or provide an opportunity to get short on any strength. I will say this to those who think the last few percentage points of declines can be attributed to the Ebola scare that has recently hit our shores: your better judgement has been quarantined by the media.
Let’s break down the causes, and then we will get to the effects.
In late 2008 early 2009 the U.S. Federal Reserve devised a way to save the financial world as we know it. By 2010, their crisis policy morphed into monetary policy. As our economy ceased its free-fall and began to recover, Europe hit its own sweet spot of a homegrown shared currency/ account balance financial crisis. In an increasingly interconnected financial world, the notion of one large economy decoupling from another country/region never really happens. So the European’s central banking overlords borrowed the U.S. Fed’s bazooka and declared that they would do “whatever it takes” to keep the EU afloat in 2012, and once we got our little debt ceiling debacle out of the way, the stage was set for a period of unprecedented depressed volatility for risk assets the world over. As they say, hindsight is 50/50 🙂 Who could have known it was going to be that easy from the end of 2012 to the end of last month??
So has the fear of the unknown associated with Ebola death and transmission added to the downward volatility? No doubt about it, at least from a sentiment standpoint. I would argue that Ebola as an excuse is more an effect of the current environment rather than a cause… meaning, after 200% gains from the bottom in the SPX in 2009, and 30% gains last year alone, our markets, and the global economy were, and remain, priced to perfection.
So why now and not last October? Simple, the U.S. Fed is nearing the end of their QE experiment at a time where it seems clear that China’s economy is stagnant and Europe is slowing. While the Taper has been known since May/June 2013, it is now nearly at its end. The U.S. Fed is left to speak to policy rather than act. By month end, they will have bought their last bond under QE and I would suggest that if they were to do an about face on that, they would lose any and all credibility in their ability to forecast, leaving further monetary policy with the potential to have little effect in a volatile global economy. So for those prepared to buy the dip as you have been conditioned to do over the last two years, it is important to note that just as risk assets can overshoot to the upside, they can also do so to the downside.
So let me state the obvious: Large cap U.S. equities (SPX and Nasdaq 100) and U.S. Treasuries have been treated as a safe have asset. U.S. Treasuries have an obvious appeal in turbulent times, the same can only be said for large cap stocks on a relative basis. My sense is there is no quick fix for the sentiment bubble that has appeared to pop, at a time when there seems to be little coordination of central bankers who are possibly operating with fairly blunt tools. We could be entering a time of financial uncertainty, not at the hands of crisis, but merely the result of the effects of large artificial footing the global economy has been on for years due to never really having a proper economic reset.