Volatility Rises
05/31/06
This May was the worst May since the year 2000. The Dow Jones Industrials lost 1.8%, the S&P 500 lost 3.1%, the NASDAQ Composite lost 6.2% and the Russell 2000 lost 5.7%. Major stock markets around the world were also hit. Europe lost similar percentages across the board and Japan lost 10% in May. The wave of selling gripped emerging markets especially hard, as India and Brazil lost 20% within two weeks. Other emerging markets suffered similar losses. What had changed out there to cause this nasty sell-off? Oil prices did not explode to the upside. International tensions did not suddenly increase, since the usual madmen in Iran and Venezuela already occupied center stage. Inflation did, however, become all of a sudden the preoccupation of the day, but was it the reason for this nasty-ness? It seems that the market has consistently underestimated the magnitude and duration of the Federal Reserve's monetary-tightening cycle. Measured inflation is rising, as are several indicators of inflation expectations. Headline consumer prices are rising at an annualized rate of over 5% so far in 2006, making it the worst start to a year since 1990. The core measure is up 2.3% from year-ago levels.
The Fed's preferred measure, the deflator of core personal-consumption expenditures, rose 2% year over year at the end of the first quarter. Other measures of inflation also appear to confirm increased pressure, including surveys like the Philadelphia Fed's prices-paid index for manufacturers, which is at a seven-month high. Import prices surged in April to a 5.9% year-over-year rate after trending lower from almost 10% in September to 4.6% in March. Average hourly earnings in April rose at a 3.8% year-over-year clip, the strongest rise since late 2001.
The two charts above show clearly that inflation measures have been creeping up for about two years now. However, it must be understood that the Fed responds to future inflation expectations, not simply recorded inflation from the past. This is more difficult to measure, though going forward, expectations deserve and will likely receive greater attention from market participants. The spread between conventional Treasuries and inflation-protected securities (TIPS) has widened noticeably in recent weeks; early this month we flirted with a 10-year spread of 275 basis points, nearly the widest ever. Of course, this spread reflects three elements: inflation, inflation expectations and a liquidity premium, as the TIPS are not nearly as liquid as conventional Treasuries. There are other developments that appear consistent with rising inflation fears, including a steeper U.S. yield curve and a falling dollar. The broad trade-weighted measure of the dollar has fallen by about 7% since early March. Such a decline offsets some of the Fed's tightening. Tony Crescenzi estimates that this 7% weakening may be tantamount to a 0.50% cut in the overnight lending rate. A falling dollar seems to offset Bernanke's efforts to contain inflation. A rising dollar might therefore help his efforts. Stay tuned for updates on the deflationary effects of a rising dollar, because the dollar will be rising again.
Life has become interesting again. Volatility increased during the month of May by over 50%. That is a lot, folks. Volatility not only signifies investors' uncertainty as far as Fed policy is concerned. It also signifies the uncertainty inside the Federal Reserve. We don't know what the Fed knows about the future, worse, not even the Fed knows what the future holds for the economy, and worse yet, they are telling us that they don't know (see the last FOMC Minutes). Many are trying to understand or explain the synchronized decline in stocks, bonds and commodities in May and inflation might have been an exacerbating factor, but it is by no means the important one. The bond market (the bigger and smarter brother of the stock market) understands this. Yields on 10-year treasury notes topped out two weeks ago, right when core inflation numbers were reported and the FOMC meeting took place that marked the top in the stock market. Anirvan Banerji from the Economic Research Institute (ECRI) says: "No wonder the up-tick in core inflation a couple of weeks ago helped spark the recent market sell-off. But it's a little late in the day to worry about inflation. After all, about 40% of the core CPI is rent, where inflation is now rising as homes become less affordable. ...." (He is referring to the noted "Home Owner's Equivalent Rent", which was explained here in our 10/15/05 Newsletter). He points out that inflation indicators shown above like the Core-Consumer Price Index and the Personal Consumption Expenditures Index are at best coincident but by no means leading indicators. Unless one thinks that their direction won't change for a year or more, those indicators are hardly relevant to the Fed's actions. Policymakers need forward-looking indicators to foresee bends in the road.
The Future Inflation Gauge constructed by the ECRI attempts to measure underlying inflationary pressures and has a mean lead time of 11 months and a median lead time of 9 months at inflation cycle turns. The FIG has been in a mild downtrend for six months, meaning that underlying inflation pressures have actually eased a bit since last fall. Mr. Banerji continues "... Underlying inflationary pressures are less of a problem today than they were a few months ago, but economic growth may now be about as good as it gets in this cycle." (see LEI chart above)
and this is the one and only reason why stocks, bonds and commodities sold off!
The contraction in junk-bond yields to historically low levels (based on a long economic boom), the strength in emerging markets (with economic growth well above world-trendline levels) and the parabolic move in commodities (China and emerging-market demand was believed to be unending) were taken for granted. Hedge funds leveraged their returns by stacking cheap debt upon their equity bases in all sorts of carry trades (funding longer-dated assets with shorter-term liabilities). Many hedge funds even sold volatility -- after volatility had fallen to record low levels. Then, almost overnight, return on capital (appetite for risk) was replaced by concerns regarding return of capital (risk aversion), as uncertainty relating to the Federal Reserve's actions, coupled with tightening around the world, created a panic in the hedge fund's crowded carry trade and the bubble was pricked as soon as somebody whispered " economic growth may now be about as good as it gets in this cycle ".
This sell-off in May was just the beginning: Global liquidity is being drained, some Hedge Funds are in trouble, the commodity bubble is deflating, leadership in the stock market is changing and volatility is rising. Yeeeehah!
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
