The VIX Boom And Bust And The Fed's Sentiment

 |  Includes: DIA, SPY, VIXM, VIXX, VXX
by: Michael Ambrozewicz


Robert Lucas Junior's boom and bust theory and the impact it has on the Fed's rationale.

Esther George and her influence on the modern behavior of the Fed.

Government stabilization and its elusory role in the American economy.

For one brief moment in our world we need to bring back an ancient philosopher named Socrates. His methodology in arriving at the truth was more with a question that the students needed to answer themselves. The truth simply lies in the subconscious of all men. Whether right or wrong, the student had to make the choice. We need to dig in deep and look into the implications and consequences of economic theory that can be used to make predictions but may not have a clear relationship to our economy. Robert Lucas Junior, an American economist, was rewarded the Noble Memorial Prize in Economic Sciences in 1995. We need to know whether his theory is now in play at this moment. In 1995, the image of the market wasn't clear enough for us to see if Lucas' theory actually worked.

In 2004, Akerlof and Yellen came out with their critique "Stabilization Policy: A Reconsideration" that questioned Lucas' theory on government intervention in times of a recession. In 2004 the market wasn't mature enough to give us a glimpse of what might happen. Lucas' assumption is simple - the market's booms and busts cancel each other out with or without government stabilization policies. He argued that even if they worked, they are pointless. Lucas' theory has more of a masculine quality that states that one must crawl before one walks as opposed to the constant nurturing that limits an American standing on his own two feet.

As a student of economics, my colleague Fiorenzo Arcadi and I need to make a bold statement that the bulls and bears are in equal footing. Both are harmonious in their outlook. Both need to profit equally. Both need to persevere in order to co-exist with each other. The bulls become bears, no different than the bears becoming bulls. Both need to preserve capital equally. The components that make up the bulls and bears rationale neither want a catastrophic failure in the American, European and/or Asian economy.

Lucas' idea that the downturns are followed by upswings of equal size theorizes that the net cost of recessions and booms is equal to zero, therefore removing the need for government policies to stabilize our economy in order to end a recession. Yellen believes that stabilization and maintenance of price stability have been important policy priorities since 1950. The decline in volatility of output and employment since the mid 1980s suggests that the Fed's efforts have been met with success and therefore "there is a solid case for a stabilization policy in the current era of low inflation."

There is a point when stabilization becomes harmful to a market. At first, stabilization helps the economy progress very rapidly with tremendous growth. However, as it progresses it becomes plagued. The printing of money has value even in the boom and bust periods. The value is based on the people who have it and the people who desire it. The preservation of money becomes more valuable in the bust periods even if it's worth less. Bankers are more apt to hoard money than lend it. Fear is more pronounced to the wealthy rather than the average American.

The bulls and the bears play the same symphony as the Fed's doves and their so called "hawks." When risk investment gets high they become nervous. Not only do the hawks convey the message, but the doves stay away. Most of the government board members come from humble rather than privileged backgrounds. The ones who come from privileged backgrounds are the bankers who advise them. They are the true hawks, that's when paranoia sits in. The bankers know that the Fed is in control. When Richard Fisher stated, "The FOMC has made money the cheapest and most widely available of any time in American history. Interest rates dipped to their lowest level in 237 years; bond and stock markets rallied to historic highs in both nominal and real terms; bankers and investors are flush with liquidity; for anybody who is creditworthy, money is uber-abundant. This will not last forever. One would be foolish not to exploit it now." Richard Fisher knows that this market will not go on forever. The bankers know that even if the market corrects itself 10% they may risk the move that there will be no more buyers of shares that they hold in inventory. The bankers must provide liquidity to buy shares that no one wants. If it keeps on dropping it will take even the market-makers by surprise and their Fibonacci rules with it.

If the markets are imperfect, then what makes the Fed more perfect than the markets themselves? On November 8, 2002, Bernanke gave a speech to honor noble prize winner Milton Friedman on his 90th birthday. Bernanke admitted that it was the Fed who caused the Great Depression. Bernanke concluded his honor to Friedman by stating, "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." This statement alone will play an ominous role in the future of economic thinkers. In 1929, the Feds wanted to "pop" the bubble because the stock market was too high. At that time, the bankers realized that nothing is real or tangible until you cash in. However, in 1929, the Fed and bankers were unfamiliar with the herd mentality. The rationale of the privileged class in 1929 was no different than a bored kid blowing a balloon and popping it, waiting in anticipation to hear the pop by jumping up and down. In 1929, the classical economist believed in the real business cycle theory. People don't work less because they are fired or laid off, they work less because wages are too low and leisure is the better option.

Are the bankers familiar with Lucas' theories of boom and bust? Without stabilization, the boom and bust periods were less catastrophic. In 1995, when government stabilization became more prominent, the markets got even bigger bringing forth greater crashes that became more catastrophic for the American public to recover from. If I can use the analogy from the movie Godfather when the patriarch advised his son, "The one who approaches you with the deal is the traitor." The patriarch is legitimizing with a few words that the threat of self-preservation is real and the very security that one might have is an illusion. The media surrounds us with intellectual writers, technicians and market gurus that continually bombard our psychic with something that doesn't exist. The market seems to continually test Richard Fisher's patience. For example, Fisher said he was concerned about the "eye-popping" levels of some stock market metrics. "I fear that we are feeding imbalances, imbalances similar to those that played a role in the run-up to the financial crisis. Fisher added, "Adding more to it is untenable, because it risks fueling a rise in asset prices to unreasonable levels and complicates the Fed's eventual exit from super-easy policies." With low interest rates, we may have inflated asset bubbles and asset prices. His comments are ignored, and many analysts and economic thinkers are weary that he may overshadow Yellen. Again, as usual, economists and analysts are wrong. Esther George of the Federal Reserve Bank of Kansas City is the logical choice to overshadow Yellen. Her doctrine is more in tune with Lucas' theories. She was the lone wolf having dissented at almost every meeting. She wants a swifter and sharper end to the central "easy money." "It will be appropriate to raise the Federal fund rate somewhat sooner and at a faster pace." She is cognizant that inflated risk assets are in play. The irony of it is that she's consistently unpersuasive in the committee just like Fisher is consistently unpersuasive toward the market.

If Esther George refuses to be emasculated by her own colleague by the virtue of what she believes in, then the real question that we need to ask ourselves is what does she see wrong with the global financial stimulus that these forward-thinking markets can't see? If Esther George believes in the economic doctrine that the political landscape polarizes between the left and right every eight years and that the policies of the left and right cancel each other out and move toward the middle then life is good. However, if the left that has administered the stimulus drug during the Clinton years was too much, then the right has become impotent because it must use the drug even more to come into power.

George Akerlof, the husband of Janet Yellen, won the 2001 Nobel Memorial Prize in Economic Sciences. Both would argue against Esther George that the Fed is in control and that the trigger mechanisms are at work. If the Dow Jones Industrial Average (NYSEARCA:DIA) drops 500 points, the trigger is set to stop and Wall Street takes a day off. Then we calm the markets the next day which leads to a market recovery of 400 points and now we can jump up and down like little kids again. To ease Esther's mind, Yellen will point out what happened in Japan in May 2013. The Nikkei was down 1,143 points overnight. The benchmark 10-year JGB yield jumped 1.002 percent as the Federal Reserve chief fuelled worries about an early unwinding of the Central Bank Program. Twice, the Japanese bond futures have been halted. Headlines: "Japan's Stocks Halted, Plunge 1500 Points to Close Down 7.3%, Biggest Drop in 26 Months." Now Esther knows that even the speculation to curb stimulus has consequences and the new sheriff in Japan had no choice but to administer the drug, but this time even more. She is perhaps wondering as to why Bernanke didn't stick to his guns of raising the fund rate when the unemployment levels dropped to 6.5%. Bernanke's successor only needed to provide continuity of his policy. The duration and timing of ending the stimulus program by $10 billion a month and then raising interest rates in the future will push the market and risk assets that fuel its own growth.

Esther's voice is being heard by her colleagues. Just recently, Fisher indicated that they are now looking at the financial markets and are starting to wonder whether tranquility itself is something to worry about. At this time, the CBOE SPX Volatility Index VIX, VIXM, VIXX, VXX does not correspond to the Fed's rationale. On June 3, 2014, Fisher indicated in a speech "When you have complacency, you're bound to be surprised at one point." William Dudley, of the Federal Reserve Bank of New York, warned that he was nervous and that the unusual low volatility in the market is bringing too much risk. Later, at a speech at the Economic Club of New York, Chairman Janet Yellen stated that "It is important to note that the tying of policies to the economy necessarily makes the future course of Federal Fund rate uncertain." The S&P 500 (NYSEARCA:SPY) and the Dow Jones Industrial Average now believe in their own infallibility and their own myth. But it gets worse for the European and Asian markets when profit taking at 300 to 400 percent is not even an option. Now the global markets have become clueless to their own invincibility. Greed has a habit of perpetuating itself whereby even profit taking has become an abominable trait. The answer may lie in the global stimulus that has given us the fear of not having more.

Sometimes in a make believe economy we need to make up a make believe fairytale. Once upon a time, an old woman was walking toward her fields and she noticed a little bear and a little bull playing with each other. The bull and the bear were happy, she contented. Ten years later she made the same trip to her fields and noticed something strange. The bull was growing horns, and the bear's teeth were getting bigger. But it seemed like they both loved each other and food was abundant for the both of them. A few years later she made the same trip to her fields again, and she noticed that the bull was eating all of the food while the bear was only getting scraps. She realized that the bull could kill the bear with its horns but the bear could inflict damage to the bull. Maybe it wasn't worth fighting with each other after all. Years passed, the bull was much bigger than the bear now, and every time the bull gave the bear some scraps the bear would throw a part of its food back to the bull. The bull was happy because it remembered the good old days of having a companion. But the old woman noticed that the bull was getting too comfortable with the bear. The bear was getting closer to the bull while they were sleeping. A few years later, the old woman decided to make a trip to her field except this time at night. She noticed that the bull and the bear were sleeping too close. The bear raised its jaw and bit the bull on its neck, killing it instantly. A year later, she returned to the fields and noticed a little bull and a little bear playing in the field. Perhaps there is a slight change in sentiment with the Fed that the bull keeps on gorging itself and now there's some sympathy for the bear.

The chart below representing the S&P 500 and the Dow Jones Industrial Average may provide some clues as to why Esther George has anxiety to where the future of the market is headed. The green arrows illustrate a healthy economy with steady market growth at reasonable rates. The 1987 Black Monday crash is signified by the red arrow. The 1990-1991 recession is represented by the pink arrow. The markets recovered steadily without heavy government stabilization policies. Both crashes were smaller in size compared to the collapses that occurred in 2000 and 2007. Hence, the market recovered and further growth was added. The key is the orange arrow. Alan Greenspan of the Federal Reserve ditched his approach to mimic adjusting interest rates based on the price of gold and instead kept the rates high even when the price of gold dropped. As the supply of money increased, asset bubbles were formed while inflation rose. Greenspan also eliminated the fractional reserve ratio, a monumental move that allowed central banks to adjust the amount of money available to an economy. This resulted in banks creating large sums of money without limitation. These stabilization policies allowed banks to pump tremendous amounts of money into the economy, leading to rapid economic growth and inflation as indicated by the black arrows. The velocity of each growth phase and decline became more powerful. The market collapses of 2000 and 2007represented by the brown and blue arrows illustrate catastrophic corrections that left a lasting impression globally.

Click to enlarge

Now we know that Lucas' theories have some validity. Some economists will argue otherwise. In the world of these intellectual economists, especially the recipients of the Nobel Prize, there is always jealousy toward the methodologies that work and the ones that don't. We can see the Fed is tightening the rules for banks. The eight biggest banks will have to meet stricter measures of holding capital which doesn't say much for regional banks that have more to lose. In 1929, the bigger banks needed to survive and got the help as opposed to the conventional wisdom that the smaller regional banks were weaker and shouldn't survive. The eight mega banks are expected to meet the five percent requirement by 2018. The question we need to ask ourselves is, if it's too late for 2014 then what makes 2018 the right option? Folks, Bernanke, Yellen, and Akerlof finished the race over 30 years ago. All three were standing at the finish line waiting. It took 30 years for Robert Lucas Jr. to make that journey, but he waited at night to cross the finish line while they were asleep. In the morning, the three were startled by a loud voice, "I have arrived."

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.