The market’s ‘fear gauge’ says it’s time to worry

The market’s ‘fear gauge’ says it’s time to worry

As all experienced investors know, October is a month to be wary of. That’s because – as history has already shown – it’s a time when stock markets like a good crash.

Except that this is 2017, and equities are playing a different game. They don’t want to fall any more. Maybe overall price levels will drop a couple of per cent once in a while, but that’s about it.

Right now, America’s S&P 500 index appears to be leading global share indices into a nirvana of ever-rising corporate worth.

Regardless of any adverse news, it seems as though investors are no longer concerned they might lose money according to the stock market’s ‘fear gauge’.

And this is when we really should start worrying…

Asset price inflation

Why do stocks keep climbing?

Following the Great Financial Crisis (GFC) that began almost a decade ago – and was made worse by some ‘clever’ derivative instruments that went horribly wrong as I wrote about here – the world’s top money men resolved to prevent another panic on their watch.

Deflation, i.e. a fall in prices, became the bogeyman. Central bankers, however, decided they could both ‘solve’ the GFC whilst simultaneously preventing another by creating oodles of extra cash.

After all, throw enough money at anything and eventually its price must rise.

So the people running the US Federal Reserve, the Bank of Japan, the European Central Bank and the Bank of England did just that.

They gave it a pseudo-technical term: quantitative easing (or QE) but in essence, they simply cranked up the money-printing presses.

Central bankers can’t, of course, actually resolve any real problems this way, as I examine lower down. In fact, they didn’t even put their monetary sticking plasters in the right place.

Rather than raising high street prices, they ended up hiking the cost of assets such as property and stocks. Which is why if you don’t already own your own house you probably can’t afford to buy one and why the S&P 500 index just keeps on rising.

Not on much bigger profits – that’s definitely not happened – but on increasingly over-extended valuations.

Put another way, investors are happy to pay ever-higher prices for exactly the same companies as before, just because interest rates are so low.

The ‘fear index’ tells the story

The bottom line is that the investment fret factor scarcely still exists. The US equity market has become hugely complacent about the risks of owning shares.

I’m not saying this simply because of the surge in the S&P 500.

You can also look at the VIX, otherwise known as the US market’s ‘fear gauge’.

Apologies for the nerdy stuff: VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index.

It’s constructed using implied volatilities – the chances of price moves – of a wide range of S&P 500 index options. Specifically it shows the market’s 30-day volatility forecast.

In simpler terms, the VIX measures the anticipated risk of being invested in America’s equity market.

High volatility is seen as bad, low is good.

Over the last 20 years the VIX has traded between 80 (expected very risky, like nine years ago in mid-GFC) and just below 10 (expected very low risk).

By now you’ve probably worked out where the VIX is currently standing.

For most of 2017, it’s been around the 10 area. In other words, it’s already tested the troughs of the last decade but now the VIX has dropped to levels seen in March 2007…in fact, just before the GFC! Here’s the 10-year VIX picture:

Can you believe it?

Calling this extreme complacency is an understatement. Once again it seems that many shareholders simply haven’t a clue how much risk they’re taking.

For one thing, US equities may already be in bubble territory. That would spell big danger, even without all the bad news around and geo-political tensions are arguably their highest levels for years.

And remember what I said about those central bankers not solving the GFC? Well, their efforts have made things much worse.

Indeed, to drag itself out of a debt/deflation downward spiral, the world created lot of extra borrowing. Worse, even more debt exists than we previously thought.

The Bank of International Settlements is often called ‘the bank for central banks’. After my earlier comments about central bankers, that might not sound too promising. However, I’d rate the BIS as one of the good guys. The bank is great at number crunching. And it doesn’t pull any punches. So when the BIS speak, I listen.

And last month the bank gave a very scary warning:

“Global debt may be under-reported by around $13 trillion because traditional accounting practices don’t include foreign exchange derivatives that are used to hedge international trade and foreign currency bonds”, reports Reuters.

Aargh! More jargon. But you don’t need to be an accountant to see the word ‘derivative’. Financial weapons of mass destruction, as Warren Buffett once called them can be lethal in the wrong hands.

“Bank for International Settlements researchers said it’s hard to assess the risk this ‘missing’ debt poses”, says Reuters. “But the main worry [is] a liquidity crunch like the one that seized FX swap and forwards markets during the financial crisis”.

And all the while, the VIX is saying there’s less need to panic than ever.
In truth, I find it hard to envisage $13 trillion, and then I looked at the latest BIS chart on overall global debt (see below). The bank’s 2017 worldwide estimate is now a completely mindboggling $217 trillion.

That’s no less than 327% of world GDP!

The scope for something to go wrong has to be…well, I’ll leave it to you to finish the sentence. Yet to repeat, S&P 500 investors are still at their most complacent.

So, the burning question now is; what next?

Well, if you are looking for an opportunity to take advantage of all of this uncertainty, my colleagues Jim Rickards and Tom Tragett might be able to help you.

You see, they’ve examined the outlook for markets over the coming months and spotlighted many of the risks, as well as looked at what to avoid. Finally, they’ve found a Big Trade for 2018 that they believe will be even bigger than any move in gold – the traditional safe haven in troubled times.

And you can find out all about it here