Volatility Down, Stock Prices Up: The Signs of a Perfect Storm

July 4 2014

“Step aside,” tells Mark Spitznagel to his investors. He hardly expects anyone to listen. “It is the hardest thing to do right now,” he says, “and makes you look like a fool.” In times like these, in times of severe overvaluation, the ones warning investors are scorned. People who risk their money at the top of a bubble get even more excited by the promise of ea

Volatility Down, Stock Prices Up: The Signs of a Perfect Storm

“Step aside,” tells Mark Spitznagel to his investors. He hardly expects anyone to listen. “It is the hardest thing to do right now,” he says, “and makes you look like a fool.” In times like these, in times of severe overvaluation, the ones warning investors are scorned. People who risk their money at the top of a bubble get even more excited by the promise of easy money. When everything goes up, everybody suddenly has the appearance of a talented investor.

The Dow Jones breached for the first time its 17,000 mark to reach its highest ever. Simultaneously, VIX — a derivative for market volatility — declined to 10.3. Only in February 2007 volatility was lower, before tripling later that year and shooting up to over 70 in 2008. While stock markets in Europe and the US are booming, volatility came to a screeching halt.

Low Volatility and the Risk of Blow Up

“Learn to love volatility,” says Nassim Taleb, author of ‘Antifragility’. Everything that is fragile is vulnerable to volatility. Hence, Taleb coined the term “antifragile” for things that benefit from volatility. The Federal Reserve, however, believes in the idea that low volatility is desirable and seeks to eliminate it at all cost. Central bankers try to kill volatility.

The Fed no longer tolerates any volatility. It lowered interest rates to levels never seen before to save banks and businesses from failing. It expanded its balance sheet to a degree it never has done before to bail out banks and other holders of mortgage backed securities. Yet the unseen consequence of their policy is that they are suppressing a healthy weeding out of bad investments. At best, they hamper economic growth and turn a recession into a depression. At worst, they will lead to even heavier losses and take a larger toll of investors in the future.

Long, Long Bull Market

We’re in the midst of one of the longest bull markets in stocks in history. The S&P 500 has been recovering for 23 quarters and gained almost 200%. This 200% rolling return was achieved only four times earlier. Once in 1937, after which the S&P 500 declined 45%; once in 1957 with a resulting 20% correction; once in the years before 1987, which of course marked the 1987 crash (-35%) afterwards, as well as the 50% decline in 2000.

Of course, even when we look at cyclically adjusted price-to-earnings ratio (CAPE) and the Q ratio stock markets are heavily overvalued. This doesn’t mean that stock markets will crash tomorrow: it could be months before prices begin to decline. It does mean that anyone beginning to invest at current levels is likely to lose money or at least suffer from disappointing returns the coming decade. It also means that investors not seriously considering “stepping aside” are likely to get burned.

Go Long Volatility, Long Gold & Short Stocks

Smart investors should consider buying the VIX volatility index as well as hedging current stock positions, if not willing to get out entirely and “step aside”, as hedge fund manager Mark Spitznagel recommends.

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