"Volatility Is Lowest Since the Great Depression"

Here's my take on why the market has such low expectations for volatility...

#1. We know that volatility tends to carry a lot of momentum with it, and also, is in general negatively correlated with equity prices, so that equities tend to go up more gently than they go down.

#2. We know that central banks are very heavily involved in markets in recent years, and are watching equity prices closely.

Thus, it seems as though investors are generally just being chased into equities by central bankers, and that there is little probability of the equities going in either direction very far without the Fed moving to counteract that move.

In other words, the Fed has effectively put the stock market on training wheels. If stocks drop too low, then the Fed will simply find a way to take more emergency stimulative measures to chase money back into equities. If stocks rise too high, then the Fed will have greater leeway to start dialing back its current stimulative measures, and this should cause the equity markets to fall back down a notch.



Okay, now here's why I think that the market has been lulled into a false complacency:

#1. Historically speaking, this is just too low, and I think that is an argument unto itself.

#2. Much like the late 1960s, there seems to be a lack of appreciation for how much instability is lurking in international markets. We are seeing people start to complain about foreign exchange policy for various currencies, and central bankers in developed countries like China and Mexico are starting to worry about shocks from somewhat hot money flooding into their economies from relative currency devaluation from the more developed economies. In sum, the super low inflation we've experienced cannot last, (A) because rises in asset prices will eventually put upward pressure on consumer prices, and (B) because capital flows going to less developed economies are somewhat ephemeral, and will eventually boomerang back into more developed economies.

If this occurs in similar fashion to 1997 & 1998, then the dollar might become super strong again relative to other currencies, but this in turn might create an overheating problem that will require the inevitable painful rise in domestic interest rates. At that point, the volatility we've been missing should hopefully FINALLY return.



Now, as with so much else since the financial crisis of 2008, there are a lot of macroeconomic corrections and other things that must happen, but that are being put off indefinitely by extraordinary policy remedies. There seems no limit to how far this transitory period can go on, and every time so far when I thought that things have to get back to normal soon, the abnormal time period has just continued to keep going.

So don't hold your breath waiting for it to end--and for the remainder of this year, it might even keep going lower--but at the same time, know that it must end eventually.

I can argue some of the semantics but mostly all you have is pretty spot on.

If you really want to see how the Fed has taken volatility out of the market, if you have access to Bloomberg go to the NSV screen. This is the Normalized Swaption Volatility screen that you can use as a proxy for rate volatility. It's basically been in a primary trend nose dive since the beginning of QE. The stock market on training wheels comment is pretty spot on as well, the Fed has a lot of leeway right now with how they can affect markets by unwinding the current programs but the effectiveness of additional measures will continue to decline.

A big question a lot of investors have is can rates go back up to "historical" levels under the current volatility of rates? Calculating the VIX is really, really damn complicated but rate volatility is more simple, relatively. Basically how much are investors willing to pay for vol in rate instruments (usually using some version of Black-Scholes). Until Fed minutes start getting more and more hawkish I think we will still have gradual movement one way or the other. You're not going to get some 1994 shock with the Fed as big of a current player in the market.

We're never going to be back in the old normal. It is, and frick me for pimping my shop, a new normal. And we will be here for a very, very long time.

Where can investors buy new equities? The number of new shares available is just insufficient to absorb all of the cash available for investment just from institutional investors. Why would institutional investors, specifically mutual funds with limited investment options, sell shares they own now if they can't replace them with alternative investments that will yield higher returns? Selling to lock in gains may get you locked out except at a higher price.

I think that is one of the reasons volatility is so low. Mutual funds owned by retirement plans hold an increasing percentage of the equities market, and they are pretty much stuck holding what they already have.

But does it all mean, Basil? (Doc)

Given the current volatility and general state of the economy, where should smart money be going investment-wise?

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We're never going to be back in the old normal.

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"The four most dangerous words in investing are 'this time it's different.'" - Warren Buffett

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"The four most dangerous words in investing are 'this time it's different.'" - Warren Buffett

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Vincent Reinhart versus Warren Buffet steel cage match, who you got?

Buffet probably has a little size but I've met Reinhart and he is a wily bastard, wouldn't underestimate him.

So are you essentially saying that sluggish global growth is going to force us to keep up with the subsequent currency devaluation bandwagon? IE, not only is the fed worried about pushing investors into equities and spurring the housing market, they are also concerned with preserving domestic manufacturing, etc.

My personal opinion is that the global economy is in a period of equalization. The populations of more countries are reaching education levels that were once exclusive to advanced nations, and it has made their populations competitive in the global labor markets. The United States does not have any sort of edge when it comes to specialization of labor for most jobs. Thus our businesses have no advantages when location is not at a premium. Trying to counter this with political solutions is a futile gesture destined to fail. The key to staying at the economic forefront is innovation. And we have no monopoly on innovation. In fact, China is likely to be the leader in innovation due to the huge numbers of scientists and engineers it is training. One only has to look at the graduate students in the physics, chemistry and engineering departments at U.S. universities to see the disparities in the numbers of Chinese v. American grad students.