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Thursday, March 25, 2010

VIX: Coincident or Leading Indicator ?...Or Is It a Lagging Indicator ?


The current large decline in the VIX (5yr chart at left), the CBOE volatility index, to the lowest levels since 2008. has sparked a good deal of writing (quotations from articles below) about what this means about what the market will be doing going forward in terms of both direction and volatility.

I think the short answer is not much in terms of the future direction of the market  Some of the misunderstanding stems from what exactly it is that the VIX is and what it isn't.  In my view the frequently cited "fear index" moniker is not really useful.

In reality the VIX can be considered "a derivative of a derivative of a derivative". The index is a calculated value of the implied volatility based on a mix of near term options on the s+p 500 futures. So the vix, the implied volatility is calculated by using the prices of options  a derivative of the s+p futures. And the s+p futures of course is a derivative of the cash value of the stocks in the s+p 500. And the options used have from one week to 37 days to expiration and are close to the money. A complete explanation of how the index is calculated is here.

Some knowledge of option pricing and option trading will help one to understand that the VIX is much more than a "fear index". A good explanation of the "greeks" of option pricing is here. Remember that the VIX is a volatility index, not a measure of any directional view (calls and puts are used in the calculation which means pure plays on volatility, which do not incorporate a directional view = straddles and strangles are affected as well . 

Buyers of options need volatility to stay high to make their options profitable. sellers make money in stable (low volatility) markets. In fact a market with very high daily or even intraday moves are good for option holders even if the market makes no significant medium term price movements. Under such conditions one would expect no declines and probably increases in implied volatility (vix).

A market that is moving slowly up or down will be bad for option holders and lead to a decline in implied volatility. A sharp move up or down in prices will lead to a move up in implied volatility although experience has taught traders that markets are more volatile on the downside than on the upside (meltdowns are more frequent than "meltups"), so the volatility of volatility is much higher when markets sell off sharply.

One more piece of the puzzle: The VIX is based off the implied volatility of very short dated options. Dead markets are the mortal enemy of option holders particularly when the options are short dated. Every day that the market doesn't move their option declines in value (time decay or theta (greek). And this theta is not linea,r the shorter the maturity of the option the greater the theta (loss per day in value), theta for options increases sharply during the last 6 weeks prior to expiry. So the very options used to calculate the VIX are those with high time decay.

When the markets are stable for a period of time option holders get uncomfortable. In the current market for example those holding long positions are experiencing  slow grind upwards with small but steady gains. The option owners on the other hand are being killed by the steady tick of time decay as their long options positions decrease in value. Gradually the option holders start to sell and some traders reacting to the stable market anticipate that to continue and become active sellers looking to collect that steady but small gain from being short options that are decaying in value each day. As option prices go down so does the implied volatility (vix) calculated off the index.

In the terminology of the option "greeks" short maturity options like those used to calculate the VIX,have high vega (change in volatility as option prices move) The short dated also have high theta (time decay) and the high gamma ("delta" sensitivity to change in the underlying and thus sensitivity of the option price to price changes in the underlying index. All this creates alot of "volatility" for the volatility index the VIX. and makes it verty  sensitive to the actual volatility in the s+p 500. A quick increase in actual volatility will leak to spike up in the vix and narrow range markets will take the vix down (as we are seeing now).

I would argue that the VIX tends to overshoot in both directions due to its extreme sensitivity to short term actual volatility in SP 500.

So is the VIX a "fear" index ? I think that is a very imprecise term for a couple reason:

1. Although it is true that the VIX goes up more during a sharp down move than a sharp upmove in the markets, a market volatile on the upside could lead to an increase in the VIX.So changes in the VIX don't necessarily give any information on market direction.

2. A market that swings with broad price ranges on a daily basis could keep the vix high even if the day to day price swings are neglible. Again not a market situation most investors fear.

3. A market that ground down at a steady rate for months on end would produce a lower vix .But that doesn't give any information of when and by how much volatility might start to increase and cetainly no information about market direction when volatility picks up.

 Right now the extremely low levels of the vix (notwithstanding the move up today - March 24) it is very close to a 2 year low. That low level is a response to the low level of actual volatility not an indication of "compacency" among traders about a possible selloff. In my view the vix is as likely to lag the market as it is to act as a leading indicator. If the market sellsoff sharply demand for options will go up  and the implied volatility and vix will go up.In the meantime there is little interest in buying short dated options that quickly give up time decay each day the market is stable, And this translates to a low VIX

Is the VIX a leading or coincident indicator ?

It seems pretty clear to me the VIX might be a coincident fear indicator or more likely a lagging indicator. In response the sharp and volatile moves to the downside demand for puts (downside protection goes) up pulling up the implied volatility of the options which translates into a higher vix. At that point one would hardly need to look at the level of the vix to know that fear is rampant in the markets.


The fall of 2008 when the VIX jumped to record levels illustrates my point. On Oct 22 the s+p 500 had a range between high and low of a bit over 9%. (5 yr s+p500 chart is pictured directly above.  The same day the VIX jumped from 53 to close to its all time high of 80. Did anyone need to look at the VIX to conclude the market was fearful ? And the 50% intraday jump in the vix from 53 to 80 hardly showed that the options market anticipated either the direction or the severity of future market moves.

In fact there is a useful calculation that can tell you what kind of move in the underlying is implied by the implied volatility

courtesy of option pundit:

Volatility is usually expressed in annual terms, and represents a one standard deviation move in the stock. Dip into any statistics book, and it’ll explain that one standard deviation, up and down, encompasses about two-thirds of all occurrences. So, two-thirds of the time, the stock with an implied volatility will theoretically be between up 35% and down 35% in one year. But how do you convert that to a more useful time frame, when most of the options you trade expire in the next couple of months?
If you assume that a stock has an annualized volatility of 35%, how much might it move in 1 day, 1 week, or 1 month? Well, open that statistics book again and see that the standard deviation increases proportionately to the square root of time. So, if there are 252 days in a year, you want to multiply 35% by the square root of 1/252 to get the 1 standard deviation for 1 day. That comes out to about 2.2%. So, in one day, two-thirds of the time the stock will be between up and down 2.2%.
To get that number for any number of trading days from today, multiply 35% by the square root of the number of days/252. That is, for the range 5 days from now, multiply 35% by the square root of 5/252. For 20 days from now, multiply 35% by the square root of 20/252. So, in 5 days, theoretically two-thirds of the time the stock will between up and down 4.93%, and in 20 days, between up and down 9.86%.
So let's plug that formula into the VIX when it hit the all time high. At the 53% implied volatility that implied that two thirds of the time the s+p 500 would  a have a daily move +/-  3.3%. At 80% volatility number would move to +/- volatility implied a move in the sp 500 of 5%. Given the extreme range (9% high to low) in the s+p 500 Oct 22 and the daily move from oct 21 to oct 22 of 5.8% the move in the vix = implied volatility would certainly be justified.

In fact in this case in Oct 2008  at the most extreme high levels for the VIX one could argue that not only wasn't it a leading indicator, it wasn't even a coincident indicator. It was more of a lagging indicator. The traders in the options market clearly were caught running (literally ) cover to buy implied volatility in reaction to the actual volatitlity.

 So that brings me to comment on two recent articles onthe vix

 Here's what recent articles on the vix have said on the message of the market in the vix's decline. My bolds my comments in blue

 From the FT

Analysts scramble to read the signs of a calmer Vix

By Aline van Duyn in New York

Published: March 20 2010 02:00 |

One of the most closely watched measures of volatility in the stock markets, the Vix index, has dropped to its lowest level since May 2008.
....The Vix was regularly on the front pages of newspapers during the financial crisis, as it rose to record levels. The fact that it is often dubbed a "fear gauge" by many market participants implies that ups and downs in this measure may say something about the future direction of stocks.
Since hitting a high in November 2008 of 80.86, the Vix has steadily declined. This week it reached 17.19, a level last registered nearly two years ago.
The question is what the 80 per cent plunge in the Vix index from its peak signals about the state of the equity markets, or their future direction. Does a drop in volatility mean all is well in the equity markets? It is a question a growing number of analysts have scrutinised, and in most cases the conclusion has been that the Vix has limited predictive powers.
"The Vix really tends to track the day-to-day movements in the S&P 500," says Dean Curnutt, president of Macro Risk Advisors. "The folks that are setting the Vix are trading equity volatility and they're just responding to how much volatility the market is experiencing now. We found that the Vix does not do a good job of looking forward." 

An analysis of the Vix and moves in the S&P 500 by Birinyi Associates, published this month, reached the same conclusion.
"The Vix is alleged to be an indicator and has become a staple of analysts and journalists alike," the report says. "We respectfully disagree and ultimately conclude it is a measure of current volatility with little or no predictive or indicative value regarding the course of the market.".....

Mr Curnutt says that the benefit of the fall in the Vix is that investors can buy insurance against a decline in shares much more cheaply, a strategy which many investors continue to pursue. Indeed, there has been some pick-up in hedging activities, as some investors see a sharp fall of the Vix as a potential sign of turbulence ahead a type of contrarian indicator.
As I noted it seems to me to be a coincident or even a lagging indicator
Not necessarily, they could be people like me with no directional view simply looking for a hedge against possible large selloffs. The low VIX levels to me are certainly a buying opportunity for a hedge that would have been done anyway, perhaps a chance to grab a bargain or average in to a long term position. I sincerely doubt that I am alone particularly with the volatility etns available (and those of course are priced off the vix futures)....

From the WSJ an attempt to read a directional forecast into the VIX which imo is wrongheaded.

A Key Volatility Index That Says 'Buy' May Mean 'Bail'

imo not only is it not the "be- all and end-all it is pretty much irrelevant.

The index, launched in 1993 with data stretching back to 1990, moves up and down depending on the price that investors are paying for options on the Standard & Poor's 500-stock index. When investors buy bearish options on the S&P, known as puts, the options become more expensive and the VIX moves higher. Conversely, when investors sell those put options on the S&P, the options become less expensive and the VIX moves lower...

(well that is just half right the vix is composed of the volatilty of both put and call options )...

If anything, the VIX is most useful as a contrarian indicator. When the index remains unusually high or low for an extended period of time, it can mean a major market change is in the offing. For instance, the VIX had trended downward, and stocks upward, for several years leading up to the Dow Jones Industrial Average's record close on Oct. 9, 2007. Then the subprime meltdown sent stocks plummeting as a historic bear market took hold.

One year later, during the diciest moments of the financial crisis, the VIX spiked to a record high of 80, capping a yearlong rise. Then it reversed course and fell sharply as stock markets enjoyed their most dramatic rally in decades.

During the fall  2008 market collapse  the s+p 500 dropped 30% in six weeks with many heart stopping days of interday moves close to 5% and wide intraday ranges. During the recovery the same magnitude upmove in the market took six months and along the way the inter and intraday volatility was far less extreme. In other words the vix is a coincident indicator. So the difference in levels of the vix during those  the markets rapid drop and its more steady accounts for the difference in the levels of the VIX>

Right now the VIX isn't pointing to a major market move, since it is just now settling into its historical range. Under normal circumstances, the index moves in a fairly narrow band, mostly between 10 and 20. Having drifted gently downward for months, the index now sits at 17....

It's not the rally that is causing the decline in the vix its the fact that the rise of the market is during a low volatility market. Low actual volatility = low implied volatility (vix)
So how can traders best make use of this oft-misunderstood index? By studying what is happening in the futures market. Professional investors have traded futures contracts on the VIX since 2004. When the futures are significantly different from the VIX itself, it is a signal that the index—and possibly the stock market—could soon reverse course. When the futures are significantly lower, it could be a bullish signal. When they are markedly higher, it could be bearish.

This seems to be a misreading. The vix futures always move more slowly than the index because they are sensitive to longer term changes of actual volatility,
The vix futures may indicate an expectation of higher implied volatility but I don't think they tell much about future direction of the s+p 500

So VIX as fear index ? not necessarily ? and it's certainly not a directional indicator ?

VIX as a leading indicator ? not a leading indicator or market direction and not an indicator contrary or otherwise of future volatility .

In my view the VIX is simply an indicator of actual volatility in the market but one that is very sensitive to changes in actual volatility particularly if it is on the downside.

Monday, March 22, 2010

Is There Still A Question Whether or Not Bubbles Can Occur ? And Why You Should Index Whether or Not You Believe They Occur

I am preparing my class to write a book review of  Justin Fox's The Myth of the Rational Market. Reviewing that material for class and my work as well as the fascinating paper by Alan Greenspan with his reflections on the crisis and the reply from Gref Mankiw all set my wheels going over whether there really is still a debate over whether the market is rational and the old saw of market efficiency.

So a few thoughts:

Mankiw's comments  ( a brief selection below) on the greenspan paper are in many ways are more interesting than Greenspan's esp the academic point Mankiw draws in challenging Greenspan about bank leverage. You can read it all on his blog.

What struck me was how Mankiw considered a "classical" economist closer to the Chicago school than the Keynesians could make this comment below , And he is making it as a point of agreement with Greenspan certainly someone not associated with the concept that markets can get prices "wrong" For both it just seems a "given" (a favorite term for economists) that bubbles and market irrationality are a part of economic life.
To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.
Quite a statement for a "neoclassical " economists

I checked my copy of Investments by Wilson and Ibbootson one of the top finance textbooks. Their definition of inefficient markets is where price does not equal value. Obviously what is described above is a market where that is the case. Ergo makets can be inefficient for a long period of time.

Now on to "rational markets'. To me it seems clear that a market where prices depart from markets in ways that are often hard to understand is almost by definition not rational

So to me it is rather clear that the idea that markets are (always) rational/efficient can indeed be labelled a myth. Maybe to be more charitable one could call it a model, a theoretical paradigm to be used as a starting point for analysis but clearly not a representation of how markets behave in the real world. Fama has a great paper on capm and these issues and basically declares that the behavioral explanation for risk not matching return is plausible. He favors the explanation that there are additional risk factors in addition to beta (size and book to market). But I'll leave those interested to read the great paper. But spoiler alert he states that in terms of using it operationally capm is useless. He still thinks it's worth teaching as an explanatory model however.

Now here is where the confusion in terms often occurs and I think I have fallen into the trap as well., Behavioral economists (i think it was Richard Thaler of the University of Chicago) acknowledge that they can point to human behaviors in markets that can lead to bubbles and busts. But they have no models to tell us when these will occur, how long they will last and how far they will go. He admits that they cannot provide any propositions that will lead to profitable activity by knowing when to short a frothy market. This is where the traditional economists' critiques of the behaviorialists come in:

The behavioralists are criticized as having a collection of tendencies in human economics behavior "anecdotes"
but no model of economic activity

The behavioralists reply that the traditional (efficient/rational market model) have a model for how financial markets work that is comprehensive but doesnt match how real people behave in the real world of financial markets. As noted Fama (the originator of the efficient market hypothesis) agrees that real world prices do not fit those predicted by capm.

I think they're both right

Following Thaler I have used the expression weak form efficient market to express the view that while there may be irrational behavior in the markets it is impossible to systematically profit from that knowledge and generate excess returns (alpha).

But strictly speaking using academic terminology I was incorrect. tTe weak form of the efficient market theory states that the current price reflects all  historical information (semi strong means it reflects all public information, strong price reflects all information public or private).

Which leads me to the conclusion that one not need believe in a an "efficient market" or a "random walk" in terms of a normal distribution of prices to believe that no one consistently beat the market = there is no alpha or as I like to say (after Taleeb) there are no geniuses.

Taleeb certainly spends much of his writing attacking premises of emh and its cousing the capital asset pricing model. Yet he also has written a womderful book called Fooled By Randomness eviscerating the idea that there are investment geniuses that can consistently beat the market.

Going one step further I noted in an interview I heard with Justin Fox the interesting point he made. One can believe in the case for indexing and the near impossibility of beating the market without at all believing that the markets are efficient (price = value) or rational. The absolute price level and movement of the market is irrelevant to the believe in the absence of consistent alpha producers.

The argument for indexing is based on the costs, explicitly in terms of fees,  less apparent but still real are additional costs in terms of transactions costs and in most cases taxes. If one wants to capture the return of the asset class with the same risk level of the asset class  (it's beta) one must purchase a low cost index instrument. It doesnt eliminate bubble or bust risk. It also doesnt tell us anything about how much of that asset class one should hold

The argument for indexing is based on cost and style purity it has nothing to do with market efficiency (rationality ) in the sense that price=value

If you think equity makets (or any other asset class) are wildly irrational price separates from value all the time bubbles and busts occur but you still want exposure to that asset class then the only correct way to do it (with style purity and low cost) is through an index instrument.

That holds :

If you believe markets are rational (price always = value) ...if there are any of you still out there.


You're like Greenspan, Mankiw and me and think that "euphoric bubbles" are as much a part of financial life as blizzards are part of weather in buffalo ny.

Of course there is another issue as well. 

Knowing that you should index tells you nothing about what the asset mix within your portfolio should be, Because no one really has a definition of what "the market" is. CAPM used the S+P 500 and a riskless asset. Clearly the investment universe is far larger than that.

More on that later.

Always Watch The Money Flow

I am certainly not one to try to call short tem market moves. On the other hand from readings in behavioral finance, studies that show that investors get returns on their investments far lower than market returns  and from my personal experience with clients and prospects some things are abundantly clear in the world of investing . One of those is  that individual investors) chase the market ,buying at high levels and selling at low levels.

Merely glancing at the chart of the sp 500 etf (spy)  above gives a small picture of this. Note the spikes in volume (bottom scale) during the big moves down starting in the fall of 2008 and the small spike in volume during the recent move up since february of this year. Even those that bought in february missed much of the market recovery and juding by the volume chart most have not yet returned to the equity market. While this is of course a partial view of the equity markets, the mutual fund data described in the article below show the same pattern.

We also know that professional money managers are very concerned with comparative performance  often even more than absolute  performance. For that reason there is a tendency for managers to move to sectors and stocks that have performed well so as not to appear underinvested in the winners and not to have their performance lag the indices. There is also a tendency to rush to invest idle cash that was not invested in equities when the equity market is performing well.

These pattern among both individual and institutional investors are most pronounced at the beginning and end of a quarter or year . For many individual investors year end and/or quarter end  may be the only times of year they look carefully at those brokerage and 401k statements For fund  managers it is the time for scrutiny of their performance in all those quarterly mutual funds reports that can drive cash flows. So flows from cash and bonds to stocks after a period of strong stock performance is very common particularly when investors seem lightly allocated to stocks.

. And it's partially a feedback loop:

The manager cares about relative performance because recent performance drives fund inflows and he is paid based on the growth in funds under management. So he moves money to chase the market winners.

And the individual investor moves money to the  top performing fund in his futile practce of chasing returns. The individual investor will of course be disappointed that past performance wasn't a good predictor of  future performance. Disappointed after a quarter or maybe a year he moves his money to the new hot fund.

That's why I think this wsj article (below) is so interesting it shows this pattern operating in real time.

 I think it is true that the combination of the markets strong performance of late and the fact that fund flows for the past year or so have been into bond not stock funds is significant. It means there is potential for more flows into stocks in the near term a positive for the equity markets. How long that will last and how large that will be I certainly can't tell you.

Can one can generate short term profits based on these anticipated flows ? I'll leave that for others to debate.

from the wsj, my bold my comments in blue

Fuel for Stock Rally: Bond-Market Exodus

First a trickle, then a flood. Investors high-tailed it out of the stock market when the financial crisis hit, pulling some $243 billion out of stock mutual funds in 2008 and 2009, according to the Investment Company Institute.
Their destination: safer havens such as bond and money-market funds. The rush for the exit helped push the Dow Jones Industrial Average down as much as 54% from its peak through the March 2009 low.
Stocks have since staged a dramatic comeback, although many investors are still parked in bonds, haunted by stock losses—a key reason many question how much further the current rally can run.
Now there are signs that investors are growing bolder.
More than $19 billion has flowed into stock funds this year, according to ICI estimates through March 10. This means the soon-to-end first quarter likely will show net inflows into stock funds, compared with a $41 billion outflow in the first quarter of 2009.....
 seems like only a tiny % of the money that went out of stocks funds has returned leaving lots of potential inflows

The pickup comes as investors have slowed their stampede into bond funds. The Dow Jones industrials and the Standard & Poor's 500-stock index have rallied roughly 70% since last March.
And the prospect of ultra-low interest rates for "an extended period," according to the Federal Reserve, also has investors rethinking their exposure to stocks.
no surprise here :
A year ago, "we could have talked blue in the face about the once-in-a-lifetime opportunities" in stocks, but clients "wouldn't even pick up the phone," says Gary Flam, equities portfolio manager at Bel Air Investment Advisors in Los Angeles. Now, Mr. Flam says, clients "are more open to it, they're proactively contacting us asking if it's time to get in."
This in turn may create new momentum for stocks.
Or here:

Of course, investors getting into the market now can't expect the kinds of returns as those who partook in the recent rally. And flows into bond funds are still outpacing those into stock funds.
Any sign, though, that the bond-loving masses may be ready to switch will give bulls another reason to cheer.

Thursday, March 18, 2010

Inflation or Deflation: The Policy Debate

I don't want to get caught up in the economic policy debate but the FT carried a provocative article if nothing else it illustrates that when it comes to economic policy and forecasting the economic future the answers are seldom clear. Economics and physics suffers from "physics envy" but when human behavior is involved the same mix of variables dont always produce the same outcome.

End this ‘inflation fundamentalism’

By Uri Dadush and Moisés Naím

it reads in part:

Since abandoning the euro looks, at least for now, unthinkable, these countries risk years of wage and budget cuts with anaemic growth, high unemployment and deflation.
There are ways to mitigate the pain. For example, Germany and other countries could adopt more expansionary fiscal policies for a while. Or, more powerfully, the wider euro area could adopt more expansionary monetary policies for several years. Today, this second option is anathema as the “inflation fundamentalists” will have none of it. This elite of central bankers, top economic officials, politicians, academics and journalists maintains the risks of allowing inflation to climb above 2 per cent are unacceptable.
Their view is informed by the disastrous experience with hyperinflation in Germany in the 1930s and stagflation in industrial countries in the 1970s and 1980s. Undoubtedly, moderate inflation can creep up to become high inflation. But, like many good ideas that take on the mantle of a cult, inflation fundamentalism can hurt. There is little if any empirical evidence that moderate inflation that stays moderate hurts growth. In most countries, cutting actual wages is politically difficult if not altogether impossible. But, to regain competitiveness and balance the books, real wage adjustments are sometimes inevitable. A slightly higher level of inflation allows for this painful adjustment with a lower level of political conflict.
Ultra-low inflation, on the other hand, can easily become deflation in a recession. Falling prices encourage people to defer spending, which makes things worse and erodes tax payments, impairing a government’s ability to service debt, which in turn increases the debt’s size and costs.
The harms of inflation fundamentalism do not stop there. A single-minded focus on inflation makes it easy for policymakers to lose sight of the broader picture – asset prices, growth and employment. Policy can become too tight or too loose – as in the run-up to the crisis in the US when low inflation was seen as a comforting sign that things were in order.
Very low inflation also reduces the effectiveness of monetary policy when growth slows since interest rates cannot go below zero. In the current crisis, governments were forced to rely too much on fiscal stimulus, and central banks to buy securities directly, taking on more risk themselves, and distorting financial markets.
The crisis in the euro area underscores the need for a more open-minded discussion of the merits and costs of ultra-low inflation, and Olivier Blanchard, the IMF’s chief economist, has just called for consideration of a more moderate (4 per cent) inflation target. This took courage. Coming from what was once the temple of inflation fundamentalism, it is akin to the chief rabbi calling for reconsideration of kosher laws.
The reaction of members of the European Central Bank council to Mr Blanchard’s proposal? “Playing with fire”, “extremely unhelpful” and even “a satanic error”. The euro crisis and the dismissive reaction to a proposal from a respected source are sure signs that the time for serious scrutiny of inflation fundamentalism has come

Friday, March 5, 2010

More on Inflation or Deflation

Interesting and well researched and writtern article (selections below) from the WSJ  

It reinforces the points I made in my blog entry that reviewed some basic macroeconomics and the prospects for inflation. It seems that when one uses the broader measure of money supply that not only is the "V" in the MV +P (money supply x vellocity = price level) quite low, the M isnt growing much either. That's because the money the fed is taking onto its balance sheet in the form of securities purchases from financial institutions. But that money is not going into the system in the form of loans. It may be due to tight credit conditions by lenders or lack of demand for borrowers. But either way at least for the foreseeable future the threat is more deflationary than inflationary.

 My comments in blue

Why Inflation Hawks Should Stand Down

by Kelly Evans

No amount of huffing and puffing can inflate a leaky balloon.(puffing on a eaky baloon or pushing on a string (keynes' term) simply easing monetary policy doesnt cause inflation)
The Federal Reserve's balance sheet has swelled to record levels amid the credit crisis, prompting concern that sharp U.S. inflation is soon to follow.
But in spite of the Fed's bulging balance sheet, the nation's money supply is barely growing. That makes the prospect of near-term inflation less likely.
On Thursday afternoon, the Fed is due to release its latest weekly balance-sheet report, expected to show a small uptick from its prior $2.3 trillion level to a record high. To put that in perspective, the Fed's balance sheet was running around $800 billion before the credit crisis.
The Fed's holdings have soared over the past two years as policy makers opened a variety of emergency lending facilities, then embarked on a $1.25 trillion program to purchase mortgage-backed securities.
These holdings could present the potential for inflation down the road as they are deployed in the economy. But right now, the system has sprung a leak.....

"It shows there isn't actually a lot of liquidity out there, contrary to popular belief," says Paul Ashworth, senior U.S. economist at Capital Economics. "It's not a good sign of healthy economy."
The problem is twofold: The credit that serves as the lifeblood of the U.S. economy and helps create money is still in short supply, and demand for it is still weak.
That raises the risk of deflation in the near term, not inflation. Indeed, core consumer prices fell in January from the prior month for the first time in 28 years.
The silver lining is these conditions also give the Fed more leeway to keep interest rates low for longer without stoking inflation. For now, inflationary fears look overblown.

And in an earlier post I mentioned what Mr. Market is saying about inflation prospects. An update on that one(wsj). Mr. Market also seems to be reading tea leaves like the ones described above and when it puts real money on the line is betting inflation is not likely in the foreseeable future. If the academic theory of monetary economics in MV=P is too esoteric, skip that and look at where people are putting real money in the's not on positions that anticipate high inflation. My bolds and blues below

TIPS Market Signals Fed Rates Can Stay Low

A closely watched gauge of inflation expectations is telling the Federal Reserve that it can leave rates low for a while to help the economy heal.
The five-year, five-year forward breakeven rate--that is, the market's expectations for inflation between 2015-2020--has come down sharply since February and currently implies an inflation rate of 2.60% for that period. That's down 0.30 percentage point from the historic high of 2.91 percentage points on Feb. 1, which implied an inflation rate of 2.91%. 
Note that even that historic high cited above is incredibly benign. A level of 2.91% is still within the Fed's long term inflation target of 2 -3% and hardly a level that brings forth visions of Zimbabwe or Weimar Germany with wheelbarrows of money being brought to the grocery market

That's a good sign for the Fed--which is charged with both promoting stable inflation and maximum employment--as it continues to battle a weak economy. With inflation not a pressing concern, policymakers can feel more comfortable with leaving policy loose and key rates near zero to support consumer spending and help the labor market improve.
The improvement "takes pressure off the Fed to respond to inflation expectations," said Michael Pond, a Treasury and inflation linked strategist at Barclays Capital in New York. Before February, breakevens were headed toward 3.50 percentage points, and that could have forced the Fed to talk tough on inflation or risk its credibility being challenged.
For Chicago Fed President Charles Evans the declines since last month aren't quite enough: He said Thursday that the inflation expectations implied by the five-year TIPS market remain "slightly elevated."
Longer-term inflation expectations have been creeping up since October 2009 as better than expected data helped convince investors that the recovery was picking up pace. But so far this year, the economic picture has been far more muddled and with stimulus support starting to ebb, any recovery is now expected to be a lengthy process. Consumer prices have also been tame so far this year: January data showed prices barely up from December and core inflation fell for the first time since the early 1980s.

Pond expects long-term inflation expectations to pick up again in the next few months, though not by much. He sees little imminent danger of a rise in inflation--his forecast for inflation by December is 1% from the year-ago month, down from 1.8% in December 2009. The Fed itself sees inflation by end-year at 1.4% to 1.7%.
Most Fed officials--even those who tend to worry about price pressures--have stuck to the line that the weak economy means inflation should remain under control. "As hawkish as I am, I don't see the case for the foreseeable future of significant inflationary pressures," said Dallas Fed President Richard Fisher this week.

Translation of the above: the economy is still very weak inflation prospects are low and the core inflation data for December showed deflation not inflation.  Even if one questions how much the core cpi which excludes food and energy actually represents the inflation consumers face, the data is striking, because if you compare apples to apples by comparing just the time series of that same data this is the first drop in close to 30 years. 

And this means again that few folks that look at this stuff carefully: analysts, people putting their money on the line in the treasury markets, or even folk at the Fed don't fear inflation at this point. They're all far more concerned that the economy doesn't pick up and we  hit a devastating deflationary cycle. That scenario which would include even worse unemployment and more foreclosures should be the focus of investors as well as those talking heads, rather than visions of wheelbarrows of money being needed to purchase loaves of bread, and the dollar losing purchasing power in a Zimbabwe style hyperinflation.

Thursday, March 4, 2010

Still Interested in Working With a Stockbroker ?

Seems that Congress has decided that (surprise) the simple issue of whether a stockbroker should be held to a fiduciary standard the same as registered investment advisors like me is just too complicated to resolve at this point. So as Chairman Dodd goes into retirement his policy idea of making this change also goes into hibernation. His successor from the same party instead proposes this beaut from the nyt article on the subject: (my bolds my comments in blue)

Senator Tim Johnson, a South Dakota Democrat on the Banking Committee, has proposed an 18-month study of the brokerage and investment advisory industries, an effort that would replace Senator Dodd’s provision.,,,,
The study proposal by Senator Johnson may be included in the actual bill, which means it would not be subject to debate. And consumer advocates contended that the study would stop regulators from making any incremental consumer-friendly changes until the study was completed. The study would also require the S.E.C. to go over territory already covered in a 228-page study, conducted by the RAND Corporation in 2008 at a cost of about $875,000, the advocates said.
“In my opinion, the Johnson study is a stalling tactic that will either substantially delay or totally prevent a strong fiduciary standard from being applied,” said Kristina Fausti, a former S.E.C. lawyer who specialized in broker-dealer regulation.
The S.E.C. has been studying issues related to investment-adviser and broker-dealer regulation and overall market conditions for over 10 years,” she said. “It’s puzzling to me why you would ask an agency to conduct a study when it is already an expert in the regulatory issues being discussed.”
Even after the study was completed, legislation would still need to be passed to give the S.E.C. authority to create a fiduciary standard for brokers who provide advice. “As we all know, the appetite for doing this in one or two years is certainly not going to be what it is today,” said Knut Rostad, chairman of the Committee for the Fiduciary Standard, a group of investment professionals advocating the standard. His group circulated an analysis that tried to illustrate where answers to the study’s questions could be found.

Far be it from me to suggest that someone staying in office would be more sympathetic to financial industry lobbyists and potential donors than someone retiring but.....the industry has been clearly fighting any change. And as an analyst of the industry notes in the same article:

Imposing a fiduciary requirement could have an impact on investment firms’ profits. Guy Moszkowski, a securities industry analyst at Bank of America Merrill Lynch, said that the impact of a fiduciary standard was hard to determine because it would depend on how tightly the rules were interpreted. But he said it could cost a firm like Morgan Stanley Smith Barney as much as $300 million, or about 6 to 7 percent of this year’s expected earnings, if the rules were tightly defined. “It’s very nebulous, but I think that is a reasonable estimate,” he added.
In a research report about Morgan Stanley last year, Mr. Moszkowski wrote, “Financial advisers will be expected to take into account not just whether a product or investment is suitable for the client, but whether it is priced favorably relative to available alternatives, even though this could compromise the revenue the financial adviser and company could realize.”

And judging from some folks who are working or have worked as stockbrokers it seems clear they are trained as salespeople to generate commissions and their behavior would likely not meet the test of fiduciary standards. Seems like that thundering herd (do they still call it that ?) and their colleagues have their eyes more on their commission statement than your brokerage statement:

Technically speaking, most brokers (including those who sell variable annuities or the 529 college savings plans) are now only required to steer their clients to “suitable” products — based on a customer’s financial situation, goals and stomach for risk. But Marcus Harris, a financial planner who left Smith Barney 10 months ago to join an independent firm in Hunt Valley, Md., said the current rules leave room for abuse. “Under suitability, advisers would willy-nilly buy and sell investments that were the flavor of the month and make some infinitesimal case that they were somehow appropriate without worrying,” he said.
Kristofer Harrison, who spent a couple of years at Smith Barney before leaving to work as an independent financial planner in Clarks Summit, Pa., said the fact that brokers were paid for investments — but not advice — also fostered the sales mentality.
“The difficulty I had in the brokerage industry” he said, “is that you don’t get paid for the delivery of financial advice absent the sale of a financial product. That is not to say the advice I rendered was not of professional quality, but in the end, I always had the sales pitch in the back of my mind.” 

Like me (in my case after an extremely short stint at a major firm that even calls itself financial advisors while in fact it is a sales organization) these gentleman have seen the light and left the dark side of the industry

Mr. Armstrong, Mr. Harris and Mr. Harrison all said they had decided to become independent because they felt constrained by their firms’ emphasis on profit-making and their inability to provide comprehensive advice.
A current branch manager of a major brokerage firm who did not want to be identified because he did not have his employer’s permission to speak to the media, confirmed that “you are rewarded for producing more fees and commissions.”While he said that “at the end of the day, I think that the clients’ interests are placed first and foremost by most advisers,” he added that “we are faced with ethical choices all day long.”

Do you really want to work with someone who each and everytime he recommends a move in your investments has a conflict between his interests and yours ? And unlike registered investment advisors like me, he has NO legal requirement to put your interests first,.

The article continues....

Unlike fiduciaries, brokers do not have to disclose how they are paid upfront or whether they are have incentives to push one investment over another. “The way the federal securities law regulates brokers, it does not require the delivery of information other than at the time of the transaction,” said Mercer E. Bullard, an associate professor at the University of Mississippi School of Law who serves on the Securities and Exchange Commission’s investment advisory committee.

 And for those hoping for more rules for mortgage brokers and lenders, credit card companies and others in the financial services.....don't bank on that one (pun intended) :

The legislative language on fiduciary responsibility was one part of the financial overhaul bill aimed at protecting consumers’ interests. Another part, setting up an independent consumer protection agency, may also be watered down.

Mr. Hougan Needs to Read His Own Sister Publication

As I noted before the "Hougan" theory about bond etfs is detached from the reality of the markets. The new issue of his sister publication entitled Etf Liquidity Explained highlights the point albeit subtly and someone not knowledgeable about how markets work might miss it.

My bolds my comments in blue

One of the most important factors in determining what is a fair price at which to trade an ETF is the extent to which the ETF deviates from its NAV. While the arbitrage described above suggests that this should theoretically never happen, in the real world—and for a variety of reasons—it does.
so here is the deviation from NAV that Hougan is so concerned with. But note its implications:

Asymmetry And Arbitrage Channels In ETF TradingAsymmetry in the arbitrage process typically occurs when the bid-offer spread for the underlying constituents is wider than the bid offer spread for the ETF itself. When this condition exists, the ETF often fluctuates between prices that are bound by the arbitrage bands: APs are unable to directly arbitrage the ETF within this band, since the cost of assembling the underlying basket of securities is higher than the bid/ask spread of the ETF itself. Understanding when and where this can happen is important for those trading ETFs, because when there is asymmetry in the arbitrage market for a given ETF, large buy orders will have a different level of impact on the ETF market than large sell orders.
For example, in December 2009, IWM had an average bid/ask spread of $0.010 per share. During the same period, the underlying basket of securities in IWM had a combined average bid/ask spread of $0.122 per share. This twelvefold difference creates a vast amount of space for IWM to trade within before arbitrage becomes profitable.

In other words if Mr, Hougan would look carefully at the Bloomberg screen he writes about it : if one were to execute market orders for the underlying securities and market orders for the etf, the etf buyer would wind up better off. In fact if the etf was bought at the offer and the stocks sold there would be a theoretical arbitrage for the etf buyer. Add in the commissions and the higher likelihood for slippage and difficulty of execution for the underlying stocks and you get an idea of the advantages of the etf

This would be even more the case for corporate bonds or high yields. The bid offer for the underlying bonds would vary among dealers and be very difficult to execute. Calculating an NAV that represents the actual prices the securities in the index could be bought or sold yet the HYG high yield etf and the lqd corporate bond etf often trade with bid ask spreads of $.01.

The article continues

Investors should be able to drive most trades in ETFs within the channel suggested by the NAV bid/ask spread. But within that channel, large buy and sell orders can and will drive the price of the ETF toward the top or the bottom of the channel.

In other words comparing prices to the NAV with corporate bonds is silly. The etf represents the market as it is trading, the market makers adjust the etf price to reflect what is going on in the market not the last reported price for all the bonds in the index no matter when they last traded as the intrinsic value on Mr. Hougan's bloomberg machine does. The bloomberg terminal is pretty usesless if you don't know how to interpret the data.

Bottom line: rather than shying away from bond etfs they are a far more better alternative than buying illiquid individual bonds with no consistent pricing. And as for the active bond mutual fund, no one really knows how much the bond prices used in calculating their NAV actually represent the price at which their bond holdings could be sold. Unlike the trading price in the etf which represents where real money is on the line for the market makers, the bond fund's NAV need have no connection with market reality. And there is not consistency among funds as to how it is calculated.

Considering  the choice between individual bonds, actively managed bond funds and etfs....advantage etf/

Wednesday, March 3, 2010

Surprise The Weak Hands Bail The Minute the Momentum Stops

The index universe blog notes this about February etf flows:

BlackRock, sponsor of the iShares family of ETFs and the largest ETF provider in the world, experienced $1.2 billion in net outflows. The company appeared to suffer in part from investors leaving the iShares MSCI Emerging Markets ETF (NYSEArca: EEM) and moving money into its direct competitor, the Vanguard Emerging Markets ETF (NYSEArca: VWO). EEM saw $2.4 billion in net outflows in February, the most of any ETF, while VWO pulled in $1.1 billion in net inflows, making it the second most popular ETF of the month.
I think they miss the significant number here investors dumped $1.3 billion in net monies out of broad based emerging market etfs (outlflows from eem -inflows to VWO = $1.3). And I would assume the bulk of the move out of eem and into VWO came from professional investors like me, I would doubt too many individuals watch management fees closely enough to make the switch.

Add in others in the top 10 in outflows(list is at bottom) and you get another chunk of outflows close to $1billion , A big surprise (not) China was #2 in outflows. Add in BRIC etfs, individual country funds other than FXI and assorted others and I would guess total outflows from emerging market etfs totaled at least $3 billion.

Little surprise, individual investor money was an avalanche into emerging market etfs throughout the rally last year. Volume spiked in the eem during the declines of late January and early February (see chart) doubtless on large scale selling judging by the volume during those market drops and the outflow numbers for the month. And as is usually the case the weak hands panicked and the strong hands did better, EEM fell  from it's 2010 high of 42.71 on Jan 4 to a low of 36.83 on Feb 8 a fall of 9.4%. Since then it has rallied back to 40.07 a move of 8.8%.

Top Ten ETFs By Outflows: February 2010
Net Flows
iShares MSCI-Emerging Mkts
iShares FTSE/XINHUA China 25
US Natural Gas
US Oil Fund
iShares iBoxx Inv Grade Corp Bond
iShares S&P Latin America 40
ProShares UltraShort Lehman 20+ Year
SPDR BarCap Int'l Treasury
Market Vectors Gold Miners
iShares MSCI-Pacific ex-Japan
Source: National Stock Exchange. Data as of 2/28/10.

Inflation in the US ? Judging By The Situation in Europe, Not Too Likely

It seems inconsistent to me that the same people that argue the most that the US economy is headed the way of Europe seem to think inflation is coming soon. I think they forget the quantity theory of money equation from the monetary from their macoeconomics 101 class (or never took it) This is despite the fact that many who think inflation is coming around the corner are arch conservatives and the major advocate of this view in recent history was Milton Friedman. The basic equaltion is this:

 MV= PT (the Fisher Equation)

Each variable denotes the following:
M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services  

.... merely raising the money supply by taking interest rates low is not sufficient to cause inflation. Without velocity from increased circulation of money through bank loans use of those loans to hire and start new business and increased consumer purchases means no velocity and hence no inflation. While I won't argue Keynes had the answer here he certainly had a good characterization of this situation. Without the "animal spirits" of businessmen and consumers there is no increase economic activity and hence no economic recovery and certainly no inflation. With the fed having interest rates near zero many  the fed is pushing on a string a phrase also attributed to Keynes simply put thing of the difference between pulling a rubber band and pushing on a ball of string

inflation or a double dip recession. Judging my this description by columnist David Leonardt of the NYT it looks like the greater risk is for the latter. In fact he notes that pushing on a string may well be what is happening

 ...the economy’s biggest problem has not changed. When bubbles pop, they wreak enormous, lasting damage. Credit stays hard to get for years because banks need to rebuild their balance sheets. Families and businesses, whose net worth isn’t what they thought it was, have debts to pay off.

Over the last two years, households have been paying down their debts at a fairly good pace. But they aren’t yet close to being finished.

The average household still has debt that eats up roughly 17.5 percent of its disposable income — in mortgage payments, minimum credit card payments and the like. That’s down from a peak of 18.9 percent in 2008. It is still above the 1980-95 average of about 16.6 percent, according to the Federal Reserve. So debt payments will continue to hold down spending in the months ahead. the fed is pushing on a string a phrase also attributed to Keynes simply put thing of the difference between pulling a rubber band and pushing on a ball of string

I wont't be as extreme as some to say the US is about to become the next Greece but the description below of the eurozone might well apply here albeit perhaps to a lesser degree. From the wsj (my bolds, my comments in  blue) In Europe and quite possibly in the US the constraint on economic growth is more likely to be deflation not inflation.

Deflation Threat Is Latest Headache for Euro Zone

FRANKFURT—European countries struggling to plug gaping holes in their state finances face an additional headache: not enough inflation.
A prolonged fall in prices, which economists call deflation, are a real possibility in some euro-zone countries including Spain and Ireland, analysts say. Others, including Greece, face years of very weak inflation. Such an outcome could make it even harder for the euro zone's weakest economies to escape the downturn, and for their governments to repair their budgets and reduce their public debts.
"It's a very strong risk that Spain and Ireland will face a very long period of deflation," as collapsing housing bubbles continue to ripple through their economies, says Jennifer McKeown, economist at London consultancy Capital Economics.
The combination of high debt and falling prices on the once fast-growing fringe of the euro zone would complicate hopes for a wider recovery in the euro zone. Spain and other countries on the bloc's periphery have been a key driver of the region's growth in the past decade.,,,

Consumer prices are already falling in Ireland. They risk doing so in Spain, many economists say, where unemployment is at the highest level in the euro zone. Consumer prices in Ireland are down 2.6% from a year ago, the biggest drop in the euro zone. ....
hat could complicate the already fragile calculations of Greece, Ireland and others as they try to rein in their bFor businesses, lower prices of consumer goods and services often mean lower profits. For governments, they mean less tax revenue, especially in European countries where sales or value-added taxes make up a large share of tax receipts......
Deflation occurs when falling prices become embedded in the mindsets of households and businesses, causing them to delay spending, investing and hiring because they believe goods, services and labor will cost less in future. Such expectations and the cautious behavior they lead to can trap an economy in a kind of malaise that has gripped Japan for the better part of two decades.

with the interest rates at near lows, lower tax revenues and stimulative govt spending reaching its limits due to budget deficits the picture is quite gloomy. And supply side myths to the contrary lower taxes might spur some economic activity but they will increase deficits. And with consumers and businesses in deflationary mode it seems unlikely they will use the lower tax rates to spend and expand. In short not pretty and certainly not inflationary. 

in fact.... 
Economists generally agree that a bit of inflation is a good thing: In moderation, rising prices help fill government coffers through greater tax revenues, and can make it easier to pay off public debts by shrinking them as a share of government revenue. More than a little inflation, however, is a menace, most economists and policy makers say, based on bitter experiences like the 1970s, when inflation in many industrialized countries undermined economic growth and employment, and required a painful spell of high interest rates to curtail....

ECB President Jean-Claude Trichet cites survey data showing professional forecasters expect inflation to be right around the central bank's target of just below 2% in five years' time.
That's true for the euro zone overall. However, the roughly 20% of the euro zone made up by Portugal, Ireland, Greece and Spain could face much lower inflation than the euro average, and possibly declining prices in coming years, many analysts say.
Note the forecasts above: the countries with the highest deficits are forecast to have the lowest infation.
 It is unlikely tax cuts would change this kind of outlook on spending:

Cost-cutting at companies is spreading to the rest of the economy. Mr. Ballantine now saves up all his spare cash; he canceled his usual family vacation, and shops more than ever at discount stores.....

"People are spending less," says Ana Ordóñez, owner of Meva, a womens' shoes and complements shop in an upscale Madrid suburb....
Many more Spanish households expect consumer prices to fall in the next 12 months than to rise, according to a survey by the European Commission, the European Union's executive arm.


Tuesday, March 2, 2010

Another Reason To Use A Fee Based Advisor(like me)

Take a Load Off: Do-It-Yourself Investors Get More Fund Choices 

The Wsj has an article on the availability of mutual funds that were only available as load funds sold through brokers and commission based advisors 

Take a Load Off: Do-It-Yourself Investors Get More Fund Choices 

Do-it-yourself investors are getting more mutual funds to choose from. Many funds once available only through financial advisers—historically, with sales commissions, or "loads"—are now available to self-directed investors without those charges.
For decades, most fund companies that sold their funds through commission-based financial advisers shied away from offering individual investors the same wares without the loads. A big concern was angering securities firms and their armies of advisers by offering the same products more cheaply elsewhere.
But amid big changes in the securities industry, some fund firms that primarily sell through advisers are concluding that it's OK to also offer their products without loads to do-it-yourselfers through discount brokerages.....
Most adviser-focused fund firms make their load-waived shares available only to clients working with an adviser, not to self-directed investors. Still, the growing use of these shares has blurred a classic division within the fund industry. Fund firms used to focus on one of two business models: They offered no-load funds to do-it-yourselfers and to fee-only advisers, or they distributed load funds through securities firms. (brokers continue to offer load funds) Now, the two groups of fund companies are doing business with each other's traditional constituency. Fee-based advisers at securities firms and fee-only advisers are both using a mix of no-load and load-waived funds....
For self-directed investors, a commissioned fund with the load waived is essentially the same as a no-load fund that never had a sales charge attached. The two would show up side by side if investors use a discount brokerage's screening tool to find funds in a particular category that are available without transaction charges. They should be evaluated on all the usual factors—including annual expenses, track record, manager longevity and strategy.
This illustrates another example of the contrast between a broker and a registered investment advisor. As a fiduciary responsible to act in the clients interest a registered investment advisor could never recommend a more expensive class of the same fund. The broker under no such standard would only be obligated to make sure the fund was appropriate to the client in the most general of terms.