A Few Thoughts On The State Of The Financial Markets

 |  Includes: DIA, QQQ, SPY, VXX, VXZ
by: John M. Mason


Three things have happened over the past six months that we need to understand: falling longer-term interest rates; a drop in the stock markets; and a increase in market volatility.

Some of these movements have resulted from changes in the economy and changes in economic policy making.

Other changes seem to be a result of the "state of the world" today and the uncertainty connected with how it will all work out.

Three facts that I would like to explore in this post.

First, the yield on the 10-year US Treasury notes closed at 1.42 percent on Friday, down from 3.00 percent on December 31, 2013. On July 24, 2014, this security closed to yield 2.51 percent.

Second, the S&P 500 stock index closed at 1,931.59 on Friday, down 2.8 percent from its record high of 1988.00 on July 24, 2014, although it is up 4.5 percent from its close on December 31, 2013.

Third, the CBOE VIX index ended the day on Friday around 16.51 which is up from 11.76 on July 24, 2014 and up from 13.16 on December 31, 2013.

With respect to the yield on the 10-year US Treasury, longer-term bond yields were expected to go up this year!

The Federal Reserve is ending its current run at quantitative easing in October. Although short-term interest rates are not expected to rise substantially from current levels of around 9-to-10 basis points, staying within the Fed's "target" range for this rate, longer-term yields were expected to rise due to a stronger economy and rising inflationary expectations.

Many analysts were expecting that the economy would grow at least by 3.0 percent over the year and that inflation would pick up, especially in food and energy costs.

The trend for this yield has been downwards from the end of last year.

In the first quarter of 2014, the bad weather in much of the United States seemed to hit the economy pretty hard and early estimates of the rate of growth of the economy for this period came in at a NEGATIVE 2.9 percent. (The year-over-year growth rate came in at around a POSITIVE 1.5 percent.)

Economist estimates for the year of 2014 were revised downwards during the second quarter…some were reduced to the 2.0 percent range.

Longer-term bond yields dropped reflecting the change in the expected strength of the economy.

In the second quarter, international events seemed to be gaining attention in the Ukraine, Syria, Israel, and other hot spots and international markets seemed to reflect a heightened concern about risk. Not only did longer-term yields in the United States drop, they also dropped in Germany, the other nation that seems to be attractive for money seeking "safety."

At the end of the first quarter, the yield on the 10-year German bund was just below 1.60 percent. On Friday, August 8, this security closed to yield 1.05 percent, a historic low.

The United States stock market continued to rise through the first part of the year. Some of us commented on the fact that the stock market appeared to be over-valued using measures like the Cyclically Adjusted Price-Earnings ratio, especially for an economy that was still not growing at a rate that indicated much exuberance.

The basic reason given for the behavior of the stock market was that it was foolish to bet against the Federal Reserve. The tapering of security purchases had just begun and it was not altogether clear that the Fed would continue along this path and bring closure to the latest version of quantitative easing. Investors in the stock market seemed to believe that going with the flow of the Fed was the best investment strategy possible for the time being.

What some are saying has acted as the catalyst that started the drop-off in stock prices from the historical peak was the statement made by Fed Chair Janet Yellen at her latest appearance before Congress. At her testimony last month, Ms. Yellen indicated that officials at the Federal Reserve felt that valuations of some stocks seemed to be "stretched." As this remark got filtered into the investment community, the S&P 500 started to decline.

This, along with increased attention given to more "hawkish" officials at the Fed has caused investors to pause a little in their enthusiasm for stocks.

Ms. Yellen's comments about "stretched" markets also included the junk bond market. Soon after the testimony there was indication that some investors were getting out of this market and this showed up with increased interest rate spreads between junk bonds and other securities that carried a higher credit rating.

That is, investors appeared to show a little more concern in the marketplace for risk. Through all the Fed's quantitative easing, investors tended to ignore risk as they searched for higher yields. As long as the Fed officials seemed to be more committed to erring on the side of ease rather than on the side of being too restrictive, investors could stretch for yield and not believe that the Fed was their protection.

Once the Fed starts warning about market strains, investors get jumpy and start to move toward less risk believing that the Fed's "put" is not quite as likely as it once was.

The changing attitudes spilled over into the volatility of the markets. The CBOE's VIX index started to rise after the middle of July and has risen in a fairly steady fashion since that time.

The markets are indicating that there is substantially more uncertainty being faced by investors now than existed at the end of last year.

And, the "hot spots" around the international scene have become major contributors to this uncertainty. At the end of last year, the world seemed to be a relatively tranquil place. Oh, there were bush fires here and there but the major worries were the strength of the United States recovery, the disinflation going on in Europe, and the possibilities of slowing growth in other areas of the world.

Now, we have the situation in Ukraine, the economic sanctions being tossed around, and the uncertainty about Russian intervention. Then there arose the conflict in Gaza and the fighting between the militants in that territory and Israel. And, there certainly not been a cooling off elsewhere. Furthermore, there is the fearful outbreak of the Ebola virus in Africa and its unknown impact.

Questions abound about how to handle the uncertainty that surrounds all these particular issues and how they will impact fund flows in the world, asset valuations, and economic activity.

To me, the existence of this uncertainty is captured in the behavior of the market numbers that were cited at the beginning of this post. The near future will see increased volatility in the financial markets, an increased movement of some investors to greater safety, and a continued disappointment in economic outcomes. Within such an environment, liquidity and the ability to move funds will be advantageous for investors.

It is ironic that at this time so much attention is being given to the 100-year anniversary of the start of World War I. One just hopes that the world is not moving into a vortex of events that will cumulate in some greater disturbance than we have experienced over the past sixty years.

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 (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.