Timing is Everything, but don't say you were not told (ThePragmaticCapitalist)

THE CANARY IN THE COALMINE?

22 MARCH 2010 BY TPC 24 COMMENTS

Over the course of the last year we have witnessed one of the greatest mean reversions in the history of markets.  And it hasn’t been unique to the equity markets.  In fact, many of the moves in other markets have been even more remarkable than the oft cited 70% rally in equities.  As prices have surged we have seen a remarkable calm come across the market as investors reach for risk no matter the news (this has become particularly apparent in recent weeks).  Some view this as a sign of optimism taking hold as the recovery expands.  Others view it as a sign of investor complacency as the underlying problems from the credit crisis remain unsolved.

In a recent note, Harley Bassman of Bank of America/Merrill Lynch referred to the many positives, but was quick to note the “canary in the coalmine” – the MOVE index.  As Mr. Bassman described, the MOVE index is the bondmarket’s equivalent of the VIX.  He refers to it as the “best gamma volatility index”.   Bassman says the recent collapse in the index is “worrisome”.   The index has fallen 80% from its post-Lehman highs. Bassman notes the tendency for the index to trade between 80 and 120 with 80 representing extreme complacency and 120 representing extreme fear.  Moves to extremes, however, are fairly rare.  As can be seen, moves below 80 preceded the 91 recession, the Nasdaq Bubble and the recent credit crisis.   The most recent reading of 76 once again implies an extremely high level of complacency:

Bassman elaborates on the outlook based on this indicator and why it represents such an accurate reading of investor complacency:

“But returning to our main point, a reading below 80 tends to presage a market problem. The reason for this signal is fairly obvious. To have an “event”, the market must be unprepared. A simple measure of the market’s preparedness is the willingness of investors to buy “risk insurance”. Since Implied Volatility is the cost of insurance, the MOVE is just such a measure. The lower this Index, the less demand there is for risk protection.

There are two observations that one can make from this chart. The first is that the lower the MOVE at the bottom of the cycle, the higher it leaps at the top of the cycle. Unfortunately, the other fact is that the MOVE can remain at a low level for quite awhile before the “event” occurs.”

The key of course, is not only understanding that complacency is very high, but also understanding that complacency can remain high for extended periods.  Perhaps most important, is understanding the trigger for a change in trend.  I would argue that several risks are now lining up at the market’s front door that could easily derail the recovery.

The most obvious risk is government complacency.  Yesterday’s healthcare vote (while an admirable social advancement) is a glaring sign of the government’s backwards priorities.  This tax now and spend later policy is exactly the kind of inefficient government spending that contributed to Japan’s prolonged balance sheet recession and destroyed aggregate demand each time it was making a comeback.  I would argue that Richard Koo’s prescription of “spend, spend, spend” is off the table on the back of this trillion dollar healthcare plan.  A second stimulus package is nearly impossible to pass now.  With government stimulus ending over the course of 2010 the likelihood of furtherhousing weakness and private sector weakness only increases.

The other great risk is China who is suffering from rising inflation and potential economic instability.  Rate hikes and the Central Bank’s attempt to thread the needle will create an enormous amount of uncertainty.  The recovery in China is no guarantee.  Let’s hope to high heaven that Congress does not follow-thru with Krugman’s ridiculous tariff recommendation.  That would almost certainly topple the recovery.

The risks are out there and markets are largely ignoring them.  The timing of such moves is never predictable, but as Bassman says:

“This warning may be early, but don’t say you were shocked later this year. “