This note was originally published
at 8am on March 20, 2012.
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“Risk appears to be at its greatest when measures of it are at its lowest.”
Keith and I have been on the road meeting with subscribers this week and spent the first part of the week in Winnipeg, so it seemed appropriate to start the Early Look this morning with a quote from Mark Carney, the current Governor of the Bank of Canada.
Setting aside the fact that Carney played hockey at Harvard, which raises some character questions in our minds, he has had a respectable tenure as the Governor of the Bank of Canada. In fact, even though we at times question too much government involvement, his actions are rightfully credited for getting the Canadian economy back to normal levels of output and employment quicker than the G-7 following the 2008 meltdown.
Personally, after reading the above quote from Carney, I was almost ready to forgive him for wearing the crimson colors of Harvard. To me that quote shows perhaps the most appropriate understanding of risk, which is that risk in the market is greatest when we least expect it. For us, a key measure of risk is volatility. As it relates to equities, a key measure of this is the VIX, or volatility index of the SP500.
Like much of modern risk management, the VIX is a relatively new creation. In fact, it was developed by Professor Robert Whaley in 1993 (courtesy of Wikipedia). The VIX is a weighted blend for a range of options on the SP500. More specifically, the VIX is the square root of the par variance swap rate for a 30-day term initiated on the current day. So, in layman’s terms, it is the expected movement of the SP500 over the next thirty days on an annualized basis.
As an example if the VIX is at 15, the expected return for the next twelve months is 15%. Over the next thirty days, the range of return is calculated by dividing the VIX by the square root of 12. Therefore with the VIX at 15%, there is 68% likelihood, or one standard deviation, that the SP500’s move, up or down over the next thirty days, will be 4.3%, or less.
In the Chart of the Day, we show the chart of the VIX going back five years. The takeaway of this chart, a point we have been hammering home as of late, is that when the VIX reaches levels around 15, it has been a contrarian signal to shift out of risk assets. In the course of the last two years, this signal has been reached three times – April 2010, May / June 2011, and now. (Incidentally, we are long the VIX, via the etf VXX, in our Virtual Portfolio.)
In our meetings with subscribers, the push back we often receive on the VIX discussion is that in the 2003 – 2007 period, or thereabouts, the VIX reached lower levels and stayed at these levels for sustained periods, which buoyed equity market returns. So, what’s different this time?
This is certainly a fair question. Our retort is that the economy itself is more volatile than it was in that period. This is due to the active management of the economy by Keynesian central planners, but also accelerating debt burdens of the economy. Think of the economy like a highly levered company, with more debt on the balance sheet a company’s earnings become much more volatile, so equity returns are inherently more volatile. (Not to mention, the “awash with liquidity” period of 2003 – 2007 was far from normal.)
In part, this is why we are long Canada in the Virtual Portfolio via the etf EWC and, if you think about, long Mark Carney policy. Canada’s debt-to-GDP is 83% (per the CIA Factbook), which while higher than we would like, is below the critical 90% bound which historically leads to slowing economic growth, and less than the United States’ ratio that is north of 100%. In Canada, the deficit is actually now in decline, which will lead to lower debt-to-GDP ratios in the future. This compares to the United States, which had the largest monthly deficit of any nation in history in February.
Another key discussion or debate point in our recent meetings with subscribers has been the outlook for economic growth, both in the United States and abroad. As we’ve stated repeatedly, we expect lower growth than many Wall Street 1.0 prognosticators. This is primarily driven by the math of our predictive algorithms and further supported by incremental data points.
For us, the price of oil is a critical data point when contemplating economic growth. As I wrote two weeks ago:
“Charles Hall, Steven Balogh, and David Murphy did an analysis of the connection between the price of oil and when recession can be expected, examining the Minimum Energy Return on Investment (EROI). In their assessment, recession is likely to occur when oil amounts to more than 5.5% of GDP. Logically, this makes sense. Even based on the very tainted calculation of CPI, the average U.S. consumer spends 9% of his or her income directly on energy, with the majority allocated to gasoline. This obviously also excludes the derivative impact of increasing energy costs, such, as we noted above, the increasing costs of food.”
Incidentally, Brent oil at $116 per barrel is equivalent to 5.5% of U.S. GDP based on current usage patterns. Brent is trading at $124 per barrel this morning.
The most recent data point supporting lower global economic growth came from the mining giant BHP Billiton this morning who said they are seeing signs of “flattening” of iron ore demand from China. It seems when China tells you they are going to gear down economic growth, they actually will.
T.S. Eliot once wrote:
“Only those who will risk going too far can possibly find out how far one can go.”
From a personal perspective, I’d agree with Eliot, from a portfolio risk management perspective, not so much.
Our immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1633-1677, $122.96-127.19, $79.33-79.88, and 1385-1411, respectively.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research