Stock Market Volatility May Be The Signal For A Crash
$VXX, $SPY, $DIA, $QQQ
Volatility (the rate at which prices move up or down) is seen in many financial markets now.
The Federal Reserve Bank of St. Louis’s Financial Stress Index, whose 18 components include yields on junk and corporate bonds, an index of bond market volatility, and the Standard & Poor’s 500 index, is almost at a 4-year high.
The restrictions on bank trading imposed by the 2010 Dodd-Frank Act, including the ban on banks’ proprietary trading and increased capital requirements, are a Key reason, at least in the US.
Large banks and other financial institutions simply are not carrying the big trading positions they once did, and therefore, liquidity in many markets has dried up.
Volatility in US markets may also be due in part to the delayed effects of the ending of QE (quantitative easing) by the US Fed late last year. Since stocks began to revive on 9 March 2009, equities have been floating on a Sea of Fed money with little connection to the slowly growing economy beneath.
Then there is the shaky base of corporate earnings growth.
With slower economic growth, sales gains have been slight. And business pricing power has been almost nonexistent, with minimal inflation and a strong USD. So top-line revenue growth, the foundation for profit gains has been largely missing.
Resourceful American businesses have cut costs and bought back stock to make up for the lack of revenue growth. As a result, profits’ share of national income leaped from the lows of the 2007-2009 recession. But profits’ share has stalled over the last several years, reflecting the slowing of productivity growth.
Stocks are not cheap relative to earnings.
The P/E ratio on the S&P 500 index over the last year is 18.2, compared with the norm of 19.4 over the last 20 years. But the better measure is the cyclically adjusted ratio , developed by Robert Shiller, the Yale University economics professor, which uses real earnings over the preceding 10 years to iron out cyclical fluctuations.
On that basis, the CAPE (current price-to-earnings ratio) of 25.84 is 55 percent above the long-run norm of 16.6. And since the norm has been about 16.6 almost since Y 1992, price-to-earnings should run below trend for years to come, assuming the 16.6 remains valid.
The past month’s rise in volatility, especially for stocks is a look back to the 19 October 1987 stock-market crash, when the DJIA dove 22.6% in one day and the S&P 500 fell 20.5%. The S&P 500 volatility in the 10 trading days before the crash was 1.8% compared with the previous month’s average of 0.8%.
More recently, S&P 500 volatility in the 10 trading days prior to 4 September was 1.9%, while the 1-month daily percentage change from mid-July to mid-August was 0.5%.
The Big Q: Is the current volatility forecasting big selloffs into inadequate liquidity, as happened in the weeks leading up to the Y 1987 crash?
Beyond the volatile markets, there are other warning signs.
Computerized trading may also be helping to fuel volatility, much as it did in Y 1987.
Junk bonds, which become very illiquid in times of stress, enjoyed huge popularity from Y 2008 until recently, as investors lusted for yield in an era of low interest rates on US Treasuries.
Recently, yields have jumped, as have spreads between Treasuries and junk bonds. Junk bond prices, led by energy issues, fell 5.7% from April through August, and investors are on track to withdraw money from junk bond mutual funds for the third year. Similarly, yields on investment-grade bonds have been rising, as have their spreads against Treasuries.
Keep an eye on the US Treasuries.
The night before the 1987 crash, 30-yr T-Bond prices leaped 12 bpts in the run to safety. Credit markets often give warnings ahead of major global economic problems and equity bear markets. That was true in Ys 2000 and 2008.
The economic outlook is uncertain, but the recent leap in Volatility in equities and other markets may be warning us of more big selloffs to come
Stocks at the close Friday in New York: DJIA +102.69 at 16433.09, NAS 100 +26.09 at 4822.34, S&P 500 +8.75 at 1966.04
Volume: about average with 810-M/shares exchanging hand on the NYSE.
- NAS 100 +1.8% YTD
- Russell 2000 -3.7% YTD
- S&P 500 -4.8% YTD
- DJIA -7.8% YTD
Have a terrific weekend.
HeffX-LTN
Paul Ebeling
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