Thursday, May 27, 2010

As fear subsides, prices should rise




The euro financial panic appears to be easing. Swap spreads are off their highs, and the implied volatility of equity options has dropped from a recent high of 48 to 30 today. This should allow substantial improvement in equity prices going forward. Europe hasn't solved its problem, but the market response to the problem has, in my view, been exaggerated. Our inefficient markets just don't have the liquidity and the transparency that's needed to keep volatility (and panics) at bay. The price of inefficiency is excessive volatility (and lots of sleepless nights). That's unfortunate, but the solution is not difficult: as the market better understands this weakness, natural market forces will be brought to bear on the problem. More and more investors will become willing to buy dips and sell rallies, and more and more will be willing to sell put and call options (both being equivalent strategies). Over time this will serve to dampen volatility, and it will help buy time until eurozone authorities figure out an intelligent response to the threat of banking system insolvency.

4 comments:

John said...

Scott,

Just want to say 'thank you' for providing such clear, rational, economic facts to those of us that have discovered this terrific blog. It is not just the charts but also the interpretation of them that I find of such value. Some of us do not agree with many of your conclusions but regardless of our various beliefs and biases your analysis challenges our beliefs and requires constructive thought.

I believe today's rally, while not ending the volatility we have experienced, will prove to be the beginning of the end of this market correction. While down days still await us, it appears to me the panic emotions have peaked for the time being and we will see more normal market behavior in the weeks ahead. We are not 'out of the woods' but your constant reminders of the strength in the US and global economy has been a most steadying influence. I'm sure I can say I speak for many, if not for most of your regular readers when I say 'THANK YOU'.

Scott Grannis said...

You're very welcome! For my part, I'm grateful for the generally high level of discourse in the commentaries.

Veneratio said...

Hi Scott,

Love your blog! I'm sure you're busy but if you have the time are you able to explain the euro/dollar swap spread? I understand the spread is the difference between the two, and I'm pretty sure swaps always refer to the trading of a variable to fixed rate(at least I believe so). Not quite understanding the logic behind them though.

Can you explain in lamens terms why the spread widened and why it contracted?

Thanks!

Jonny

Scott Grannis said...

Veneeratio: swaps are not easy to explain but in this Case you can think of the swap spread as a measure of how reluctant people are to enter into financial relationships with counter parties. The higher the spread the greater the fear that your counter party in a transaction may default on his obligation. Wide spreads are a sign that there is a lot of fear that banks may not be able to fund themselves and may end up insolvent.