Friday, November 18, 2011

Panic exhaustion revisited



Comparing the level of the Vix Index of implied equity volatility to the level of the 10-yr Treasury yield is a handy way of gauging how extreme market sentiment is. The Vix index is a good proxy for fear (because the implied volatility of options determines how expensive it is to purchase options in order to limit one's downside risk), and the 10-yr Treasury yield is a good proxy for the market's long-term outlook for growth and inflation. When you combine a high level of the Vix with a low level of the 10-yr, you have a market that is not only very fearful but also very pessimistic about the future. The top chart shows the ratio over the past two decades, while the bottom chart zeros in on the ratio over the past 4 years. Bottom line, we are living in times of great fear and pessimism.

I wrote back in July ("Carmageddon, free markets and the PIIGS crisis") about how fear, knowledge and time can short-circuit prophesied disasters, and I suggested that the PIIGS crisis might therefore end with a whimper instead of a bang. I still think that is possible, and the more time that passes, the greater the likelihood that of even a multiple PIIGS default will prove to be much less awful than the market currently fears. After all, the world has had almost a year and a half to adjust to the risk that the PIIGS countries were in trouble and might default. That's a lot of time, and any sentient investor or risk manager with serious exposure to a PIIGS default most likely has taken steps to reduce his exposure. When risk is hedged it is diversified, so PIIGS default risk has likely been spread out over much of the world; and of course the ECB and Germany have in the meantime been willing to shoulder a good deal of that risk.

To judge by the Vix/10-yr ratio, markets and investors have only been so consumed by fear, uncertainty, doubt, and pessimism once before—the period starting with the collapse of Lehman in 2008 and ending with the beginning of the current recovery in mid-2008. But back then we did have monster defaults and we saw the decimation of banks and their balance sheets, and we did have a global economic collapse and a financial panic that brought us very close to the feared abyss called "the end of the world as we know it." Today we have been waiting 18 months for this to happen again. I reiterate what I described three weeks ago, in my mid-September post on panic exhaustion: debt defaults don't destroy demand, banks can be recapitalized, government spending cuts actually make the outlook rosier, and most of the damage from too much debt has already happened. "The failure of a bank is simply the last chapter in a book about money being flushed down the toilet. It's not the end of the world."

It's not that the suspense of a PIIGS default is killing us. The longer the suspense lasts, the less likely it is to kill us.

15 comments:

Benjamin said...

I hope policymakers choose the courses of action that encourages increases in output.

If your are over indebted, the right course of action is to work harder, and increase output, not to pull your horns in.

Western economies seem to "solve" debt problems by having recessions and defaults Not the right tactic.

Unknown said...

This is similar to something Cullen Roche recently wrote.
LINK

On the other hand, this here was disconcerting.

But speaking of the LEI, how about THIS?

I have a feeling we could get a period of rapid growth while the stock market languishes, for the reason that the dollar will go up while Europe falls apart (seeing as how the stock market doesn't seem to like a rising dollar anymore)

Hans said...

I am not sure whether those that maybe effected that taken the corrective action.

This would had lead to very large losses, none of which I have read or heard.

Hear is another POV:
http://news.yahoo.com/next-financial-crisis-hellish-way-204303737.html

There is simply nothing transparent about the financial industry; as most people including myself, do not understand their accounting procedures..

I suspect, the truth of the matter will fall somewhere between the two extremes.

The damage may also come from investors emotional panic, of what they perceive as real..

Hans said...

Unknown, I am sorry, but for me the VIX Index is for all practical purpose, worthless as a tool for investing or trading for that matter.

Bill said...

The funny thing about fixating on a worst case scenario is that if it actually occurs, then you have lived it twice.

William said...

Off Topic: I am old enough to remember back in the 1970s and early 1980s that international central banks made a coordinated effort to intervene in the currency market when they thought there was undo speculation driving trading in a particular currency. It was a coordinated effort to punish traders and hedge funds using margin that were disrupting commerce.

This came to an end when England - acting alone - lost a few billion Pounds attempting to defend the falling British Pound. One doesn't read much about coordinated intervention in recent years.

But I have been wondering if major central banks might make a coordinated intervention in the Italian and Spanish bond markets if traders push 10 year rates much above 7%.

Dr William J McKibbin said...

No one except the unemployed have a right to be "exhausted" in the US at this point -- the hard part has not even begun...

On a separate note, I predict a generational change in leadership in the next election -- anyone over 65 who is up for reelection is unlikely to survive the the 2012 elections -- moreover, Americans older than 55 (including myself) are about to become irrelevant at best, or obstructionists at worst -- change is inbound -- by the way, the imminent collapse of the Eurozone coupled with the upcoming default of California are going to make the future a young man's game anyway, if for no other reason than it will take an entire generation to fix the US and global economies -- all eyes should be on the recovery of 2035-2040 at this point -- those who still have cash shouuld be buying cheap dividend and rent-paying equities until then -- everyone else should prepare for economic depression...

Dr William J McKibbin said...

PS: Dividend and rent-earning equities are the only remaining safe-havens for wealth -- bonds and cash are about to collapse in value as the global monetary system recreates itself in come new image, a process that will take decades -- world-class skills will also retain value -- those who work for the government, or rely upon entitlements, defined benefit plans, or government salaries and pensions are about to experience declining lifestyles unless they have separate investment portfolios to draw upon -- like I have been saying, now is a good time to take cover...

Tyrone said...

FYI: Off-topic
I just saw your niece (Kina) on the Yahoo main webpage featuring her viral jelly bean video.
(11/19, 7:14PM Pacific)

mmanagedaccounts said...

The global significance of Europe remains puzzling to me. Economist Larry Kudlow doesn't think the EU crisis is that important while John Mauldin views it as critical to the U.S. economy. Who is right?

World equity markets continue to be in turmoil---largely due to worries over Europe. First there were the smaller PIIGS, then Italy and now we can begin to add France.

France and Germany cannot agree on a resolution.

There's too much uncertainty in the world: Europe, the U.S. debt debacle, China's growth, etc., all causing capital markets to tank and thereby losing trillions of dollars of equity.

The world is in a mess. Elvis is dead and I don't feel so good myself.

ant said...

Keep up your good work.

Mike Eliason said...

Scott,

The ECRI is calling for a double dip. I'm curious about your thoughts on their analysis.

http://www.businesscycle.com/reports_indexes/reportsummarydetails/1091

Benjamin said...

Ugly out there. The Super Committee laid an egg.

Thank you, Democrats and Republicans.

Scott Grannis said...

Re ECRI: I have great respect for ECRI, but economic forecasting is not a science and therefore anyone can be wrong. Their recession call was made a few months ago. So far I haven't seen any signs of an imminent recession in the things I consider to be important leading indicators. Slow growth, sure, but not a double-dip recession. But of course I could be wrong.

Jim said...

Something to keep in mind. The arbitrage programs are creating a whole new world out there. Historical volatility may be irrelevant.