The recent market activity can be summed up in one word: volatility. We haven’t seen this kind of volatility in years. The VIX, which measures the implied volatility of S&P 500 index options, has spiked. Not only that, but it remains at high levels which is unusual and may indicate prolonged volatility.
This volatile market has made it an extremely difficult environment for traders. The market jumps several hundred points one day, which appears to be the beginning of a really, but the next day it falls back again. Rather than finding a trend in either direction the market continues to seesaws up or down.
Much of the volatility has come from worrisome news out of the PIIGS nations in Europe, which are on the brink of collapse and could trigger another Lehman event. Other news such as the latest jobs numbers and disappointing economic data has also created an environment of uncertainty.
However, there is another cause for the increased volatility and it is perhaps the biggest contributor of all. In an interview on King World News, Jim Rickards explains how the Fed's manipulation of interest rates has led to increased volatility in the stock market. He calls this new trend the “conversation of volatility.” He explains that the three most important trading markets in the world - the stock market, the bond market, and the currency market - are interrelated. For example, as interest rates in a country go up, the currency of that country strengthens. Furthermore, rising interest rates put downward pressure on stocks because the discount rate applied to future earnings is greater and present values are lower.
These three markets have always been volatile but that volatility would shift as one market affects another market. For example, if stock prices would rise sharply, interest rates rise as credit demands increase and inflation takes off. This would then dampen the rise in stocks and shift volatility from stocks to bonds. The same process occurs between rates and currencies and the volatility will move around and be absorbed among the different markets.
However, this all changed with the Fed's decision to hold down interest rates and flat out the yield curve with its new “operation twist” program. The Fed has essentially taken out volatility in the U.S. Treasury markets. Because currencies move largely based on interest rates, reduced volatility in interest rates also means reduced volatility in the foreign exchange market. Since volatility has largely been taken out of the U.S. treasury markets and the FX currency market, all volatility must therefore go toward the stock market, since there is no longer an interest rate mechanism to absorb the shocks in the stock market. The result of all this is greater volatility in the stock market. The popular measurements of volatility, VIX and VIXY, tell the full story.
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The VIX has spiked from $15 in July to $45 in September.
This high level of volatility and uncertainty has scared away some traders and investors. Many traders have simply thrown in the towel and decided to sit on the sideline for the time being. This in itself has perpetuated volatility as investors have withdrawn liquidity. With fewer investors in the market it takes fewer and smaller orders to move the market in either direction.
This increased volatility also affects the gold (GLD) market, which has been a source of stability and certainty. In the short run, this will mean volatility in the gold sector as hot money is chased out. Many funds have also been forced to sell of gold to meet margin calls. However, in the long run the safe haven of gold will become ever more apparent as investors look for a source of stability and certainty, which gold has represented for over 5,000 years.
Disclosure: I am long GLD.