Volatility still high, but service sector still fine; plus a note on the role of hedge funds

Markets are still on edge, worried that a China slowdown will prove contagious to the rest of the world—a new twist on the old catchphrase "When the US sneezes, the rest of the world catches a cold." But the mainstay of the U.S. economy—the service sector—is still quite healthy. The U.S. economy has been underperforming for years, but that has everything to do with our own bad policy choices. Even a substantial slowdown of the Chinese economy would have little impact on the U.S., since China's purchases of goods and services from us represent a mere 0.7% of our annual GDP. 

As the chart above shows, the service sectors of both the U.S. and the Eurozone have been gradually improving over the past year or two (and the U.S. survey beat expectations, 59 vs. 58.2). This arguably trumps any slowdown in the growth of the Chinese economy.

The Business Activity subindex of the ISM service sector survey is still at historically high levels, and doing much better than at anytime during the current expansion. This represents about 80% of our GDP. This is great news.

The Employment portion of the ISM service sector survey is still at relatively healthy levels. This suggests that businesses are reasonably confident about their future prospects.

Despite all this good news, the market remains very nervous. The Vix/10-yr ratio today was about as high as anytime in the past two and half years (excluding last week).

The chart above compares the daily closes of the S&P 500 and the Vix index. Note that the two lines are virtually mirror images of each other. Rising fears accompany lower stock prices, and vice versa.

The chart above uses the same indices as the previous charts, only it flips the Vix index to show how the two move in inverse lockstep. The correlation between these two series is an impressive 0.87.

Background: the Vix index is the implied volatility of equity options. As such, the Vix index is a proxy for how cheap or how inexpensive options are, because the more volatile prices are, the more likely an option is to hit its strike price.  A higher Vix thus implies more expensive options. Buying options is a classic way for investors to lower their risk profile, since the worst that can happen to an option you purchase is that it expires worthless. In contrast, the worst that can happen if you own stocks is that you can lose everything. But if things go well, buying call options gives you the opportunity of participating in most of the upside of stock prices, and buying put options gives you the opportunity to profit from most of the downside of stock prices. When people are nervous about the future, one natural strategy is to replace outright ownership of stocks with call options, and to replace outright selling of stocks with the ownership of put options. But either way, the more nervous people get, the more expensive options become.

What many investors arguably fail to appreciate is that the people selling options to the public are not likely taking on unlimited downside risk by being "naked" short sellers. They are hedging their positions by selling stock as stock prices fall, and buying stock as prices rise (aka "delta hedging"). If there is a surge of interest in buying stock options, the sellers of those options must immediately establish a hedge by selling stocks. So there is a hedging connection between implied volatility and stock prices: the higher the implied volatility the more selling of stocks there is, and vice versa. Bloomberg has a story today which helps to explain this.

What all this suggests to me is that the volatility of stock prices is almost exclusively a function of the market's intolerance for risk. Fears, not reality, are the driving force behind volatile stock prices, and the mechanism which links fears and stock prices is hedging (e.g., mechanical) activity, not necessarily a deterioration of the economic fundamentals. This type of hedging activity has the potential to destabilize markets if mechanical selling overwhelms the ability of natural buyers of stock to respond. But at the same time, the higher cost of options provides a huge incentive for speculators to effectively become sellers of options and (via their hedges) buyers of stock. These episodes can be terribly nerve-wracking, but eventually they sort themselves out and the fundamentals reassert themselves. I suspect that's what will happen this time too.

Chart update IV

The only thing that has changed meaningfully in the past week or so is volatility: both implied volatility and the volatility of stock prices. Swap and credit spreads, gold, commodities and the dollar are largely unchanged in recent days.

What's the source of the volatility? It could be the disconnect between investors' fears of the future and the lack of evidence that the fundamentals of the U.S. economy are deteriorating. Fears can't get traction if they don't impact the economy in some fashion, but they can make for choppy markets.

ADP has been doing a somewhat better job of late in predicting the monthly change in private payrolls. Their estimate (released today) for August (+190K) is pretty close to the market's guess (+205K, to be released by the BLS this Friday), and either value would be a nonevent since it wouldn't represent much of a change from the average of the past several years, and it would be well within the normal monthly variation.

Chart updates III

Unusually high volatility and widespread nervousness continue to plague the markets, but there is still little or no evidence of any significant deterioration in the economic and financial fundamentals. On the contrary, recent releases show that the construction sector is booming and auto sales are at a 10-year high. Moreover, swap spreads—a key current and leading indicator of economic and financial market health—remain quite low, suggesting systemic risk is de minimus.

The Vix index (implied equity volatility) jumped to 32 today. Even though that is substantially elevated from the 12-ish value that prevails during periods of "normality," it is nevertheless much less than the panic high of 53 that was briefly reached last week. A similar result holds for the ratio of the Vix to the 10-yr yield (a ratio I prefer since the 10-yr yield is a good indicator of the market's outlook for economic growth; thus, a high level of the Vix/10-yr yield is indicative of a lot of nervousness and a lot of pessimism). A high Vix/10-yr ratio tells us that the market is pricing in some pretty awful stuff. If the reality subsequently proves to be less awful than the expectation, that forms a solid basis for a rally. I think we'll see this once again.

The ISM manufacturing index has been a little soft of late, but it is still suggesting that overall economic growth is 2-3%, which is what the economy has been averaging throughout the current expansion. Although soft, the ISM index is not even close to predicting a recession.

July construction activity was much stronger than expected, and it came on top of substantial upward revisions to prior months' data. Construction activity is booming, growing at strong double-digit rates. This is a very positive development.

Export orders were the weakest component of the August ISM indices. It's clear that the market is worrying more about developments overseas—notably a slowdown in the Chinese economy—than it is about anything going on in the U.S. economy. In that regard, I note once again that U.S. exports to China represent only 0.7% of our GDP. China is undoubtedly slowing down, but this is not a significant threat to the U.S. economy. On the contrary, the recent weakness in the yuan will ensure that Chinese goods reach our shores with low and very attractive prices. That is an ongoing boon for U.S. consumers.

Donald Trump needs to take a refresher course in the dynamics of international trade. If anyone is taking advantage of anyone else, it's the U.S. taking advantage of China, and we would be crazy to complain about our ability to buy incredible Chinese-manufactured goods at incredible prices (e.g., iPhones).

August vehicle sales were stronger than expected, and they now stand at a 10-yr high. This chart is a classic V-shaped recovery chart. Consumers are doing just fine.

The prices of gold and 5-yr TIPS continue to follow a slowly declining trend. This means that the world's demand for "safe" assets continues to moderate, and that dilutes the message coming from the elevated Vix/10-yr ratio. If things were really falling apart, the world would be much more anxious to seek out the safety of gold and TIPS.

Swap spreads have been excellent forward-looking indicators of economic distress. At current levels, they are telling us that the U.S. and Eurozone economies remain healthy.

High-yield spreads are a bit elevated, but still far below the level which would signal a substantial weakening of the economy. Most of the spread widening is coming from the energy sector, and spreads there have backed off of late, thanks to a significant bounce in oil prices. Swap spreads are very low, and that suggests that the recent bout of nerves in the corporate bond market is likely to pass.

Bloomberg's measure of financial conditions has deteriorated somewhat over the past year, but it is still far above the super-distressed levels of 2008. Conditions were much worse in 2011, around the time of the PIIGS crisis, than they are today.

Declining crude oil prices explain most of the decline in near-term inflation expectations. Nothing unusual at all about this. Lower energy prices put downward pressure on inflation, while at the same time enabling an increase in global economic activity. Lower inflation and stronger growth are a great combination!

Gold and commodity prices continue to trend lower, but they are still very high relative to their 2001 lows. This is not so much a "collapse" in prices as it is a return to more normal levels. As with energy, cheaper commodity prices make it easier for the global economy to grow, especially when lower commodity prices are the result of big increases in commodity supplies and production. For proof of the latter, look no further than the 85% increase in U.S. crude oil production over the past 5 years: