Friday, January 22, 2010

Implied volatility update



This chart shows the implied volatility of equity and T-bond options. Implied vol can be thought of as a proxy for the level of fear, uncertainty and doubt that inhabits the market. Implied vol has fallen sharply over the past year as the market's many and deep-seated fears were resolved: the economy hasn't fallen down a black hole; this isn't another Depression; there is no deflation; Obama is not going convert the country to socialism; we aren't going to have a global trade war; political balance (gridlock is a good thing) is returning; there are many signs of recovery.

There are still lingering concerns, of course. How fast will the recovery be? Are we being set up for another slump? How will the Fed reverse its quantitative easing? Will inflation go up a little, a lot, or not at all? Will trillion dollar deficits go on forever? Will businesses find the courage and the capital to create new jobs?

Despite these concerns, I think there has been enough progress on many fronts that the future looks appealing, if not bright. Our financial markets have largely healed, and our political system is working to provide checks and balances. The economy has undergone a tremendous adjustment process, with the result that we now have a relatively solid base upon which to build a recovery. The housing market has also undergone radical adjustment, with an unprecedented decline in prices and residential construction, but this also is a necessary step and a base upon which to mount a recovery. The global economy is recovering as well.

I think it still pays to be an optimist.

14 comments:

Bill said...

So, should I go ahead and book the cruise for Spring break even though some folks think Obama and Co. are going to send the economy over the cliff?

Jeff said...

It would be nice if Obama would stop his populist reterick (sp?)....when is he and everyone in his administration going to realize that just about everyone (including Unions and everyone with a pension) are investors..his anti wall street, anti banks, etc etc hurts everyone!!! Let the markets work, allow capital and informed risk taking to occur again, quit trying to "manage" everything from the White House...this guy is truly going to hurt this country!

alstry said...

Scott,

You did a great job explaining how credit credit from one to another simply shifts demand a few blogs ago.

Could you explain how total credit in America expanded from about $25 Trillion in 2000 to over $50 Trillion in 2008 yet money supply didn't grow nearly as much.

Where did all that credit come from without expanding money supply?

Thanks.

Ed said...

@Scott,
can you see any signs of improvement in the commercial real estate market ? Moody’s/REAL All Property Type Aggregate Index was up yesterday (+1% m/m)but sales volume is very very poor in Nov. ( $4.1bln vs. $69bln. in Feb. 2007). About 52% mortgages are "under water" and $1.4 trillion got refinanced until 2015.
So what do you think about commercial real estate market ? I enjoy reading your blog !
Thank you

brodero said...

The S&P 500 is a cheap buy ( except in freakouts like 2008) when
it trades 1:1 to NIPA corporate profits after tax.This number was 1038 at the end of the third quarter.Estimates have the fourth quarter between 1150 and 1200. Selloffs are a buying opportunity.

Scott Grannis said...

Ed: Thanks! I'm no expert on CRE. I doubt it has bottomed. But I am pretty sure that whatever losses there will be going forward have already been priced in to CMBS. The market has effectively absorbed already all the losses that will happen. Now we are just playing clean-up, and waiting to see if the actual losses exceed the estimated losses or not.

Scott Grannis said...

brodero: that is an interesting observation. The two series do appear to track each other over long periods. I'll have to look into this some more....

Scott Grannis said...

alstry: credit expands without creating more money just as I explained in my post.

Scott Grannis said...

Bill: be an optimist. I think the developments of the past week are very bullish. Obama & Co. are finding that their policies are way out of step with the wishes of the people. They are going to be forced to move to the center.

Bill said...

Scott,

I know you're not a fan of Bernanke. Won't the markets go into a tailspin if he's not confirmed?

Scott Grannis said...

There is already a serious risk that he won't be confirmed, and this could be contributing to selling pressure this past week. In the end, though, what's important is who replaces him. Bernanke hasn't done a very good job, but the list of those who could do better is pretty short. John Taylor is the first one to come to mind. Donald Kohn seems to be on everyone's short list, but I don't think he would be preceived as necessarily worse than Bernanke. Chris Dodd, however, would be disastrous, but I have real trouble believing that he could be confirmed.

There are real risks involved here, and I think the market is already very concerned. If the market is efficient and smart, and I believe it is, it won't be very disappointed if Bernanke leaves. What will be more important is who replaces him.

Remember also that the Fed has a deep and strong bench in the form of "institutional memory" which effectively rules out any big changes in operating procedures. In the post-Greenspan era, the Fed is no longer a one-man show.

alstry said...

Scott,

What percentage of GDP growth over the past decade was directly attributable to the expansion of credit?

How much do you think GDP will contract as credit is curtailed or defaults.....?

Thanks.

Scott Grannis said...

Since credit expansion can't create new demand, the expansion of credit adds to GDP only marginally, by distributing demand to areas of the economy that need it but might not otherwise get it. Credit is one way that savers are connected to spenders; an expansion of credit more efficiently connects savers to spenders.

Ergo, the big contraction in credit and all the credit defaults have not had a significant effect on GDP. Creating credit did not add to demand, and destroying credit does not subtract from demand. The credit contraction has had the effect of throwing sand in the gears of commerce, slowing things down somewhat. I'm going to guess that GDP is no more $300-400 billion less, because of the credit contraction, than it otherwise might be if the economy were at full employment. Compare that to the trillions in credit writedowns and defaults.

alstry said...

I am not sure I understand your logic on this one.....from this perspective it seems credit creation drives demand.

In Florida, homeless people were qualifying to purchase homes.....if the credit was not avavilable, homes would not have been purchased. The same can be said for automobiles, travel, and construction.

It is often said that builders will build to the limit of credit available......it is simply human nature for many.

Since Credit has been curtailed....new home construction is down 80%, auto sales down about 50%, commercial construction coming to a grinding halt, and travel down about 25%.

These are depressionary numbers.....and seemingly, the only thing keeping our economy going right now might be Obama borrowing a few trillion per year to help offset the decline in credit extension to the private economy.

What if we transferred all of America's savings through credit expansion to borrowers who consumed it and have no means or capacity to pay the loans back(M2 is only a fraction of total debt)......how do you see the economy recovering without massive inflation coming out of Washington?