Nothing in life is to be feared, it is only to be understood.
Now is the time to understand more, so that we may fear less.
If you follow the financial news daily, you are constantly bombarded with headlines predicting the best of times or the worst of times. Case in point – The Fear Gauge! The Fear Gauge or CBOE’s Volatility Index (ticker symbol VIX) just hit a 23-year low or three week high or maybe as some suggest the fear gauge may not be that significant after all… So which is it?
What is the Fear Gauge?
I bet many of you are asking, so what exactly is the Fear Gauge? The following is a definition from Investopedia:
“VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking. It is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the "investor fear gauge."
That was helpful… right?
Perhaps Wikipedia can help us understand how to interpret the VIX (volatility index):
“Although the VIX is often called the "fear index", a high VIX, is not necessarily bearish for stocks. Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside… Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. Only when investors perceive neither significant downside risk, nor significant upside potential will the VIX be low.”
If I were to read between the lines – The VIX measures how volatile investors think the market will be going forward; with a low VIX reading implying that investors don’t expect the market to move sharply in either direction. A high VIX reading implying investors expect the market to move sharply in either direction. This would imply that directional changes to the VIX might have some predictive correlation of the directional changes to the market.
The Relationship of the S&P 500 to the VIX
The chart and table below from the CBOE explores the relationship between the S&P 500 and VIX Index. Essentially, the chart and table show that directional changes to the VIX are about 80% accurate in predicting the direction of the S&P 500. For example, when the VIX is going down, the S&P 500 is going up 82.15% of the time.
Is the Fear Gauge Broken or is it the economy, stupid?
Today the VIX is hovering around all-time lows (see chart below), which has led many commentators to question the validity of the VIX or for the negative market pundits to call this the quiet before the storm – there is a “black swan” event looming that will take down the market.
The VIX doesn’t appear broken; rather like Bill Clinton once said… “It’s the economy, stupid”. In our view, the VIX is hovering near long-term lows because the economy is actually plodding along with good corporate earnings and private sector job growth. In addition, it is interesting to note that market fear hasn’t ticked up significantly with the technology profit taking over the past few days. To be clear, it has hit a 3-week high, but the VIX is still hovering around long-term lows. Investors don’t appear to be fleeing to the safety of bonds; rather we have seen a quiet rotation in the past few days, from technology stocks to financials and to dividend payers. It is too early to consider this rotation a trend; however, in our portfolios we have slowly added to our dividend payers while taking some profits from the technology sector.
At Kabarec Financial Advisors, Ltd., we will continue to monitor the VIX for directional changes that could truly indicate volatility ahead. In the meantime, I hope this has helped you understand more so you can fear less.
Volatility is on the forefront of our minds as 2015 comes to a close. For the second half of the year we experienced a significant increase in volatility as China concerns slipped into play, Greece stumbled, Puerto Rico tripped into bankruptcy, and our slow but steady market fell into an era of volatility. We expect this era to continue into 2016 as the Fed’s program of rate hikes are projected to continue even as Europe and Japan enhance monetary easing measures. The Kabarec team is working on reducing your portfolio’s exposure to market volatility while maximizing your return.
We have allocated more toward a cash position and chopped some of our holdings that were more susceptible to wild market swings. By effectively taking risk off the table we have placed your assets in a position to capitalize when the market finds stability. Our purpose is to earn you the highest return by investing at the most opportune time. During volatile times it can be difficult coming to a fair valuation on a holding due to firms and individuals investing on emotion and trend rather than true fundamental analysis. Our convictions in investing have always been driven by fundamental financial ratios, key statistics, and performance outlooks as opposed to fear and greed. We will continue to hold steadfast to this philosophy into a volatile 2016.
The New Year will usher in a new election cycle and new policies will shape the economic landscape for years to come. We look forward to the strong possibility of international tax reform. An end result of tax reform would align the U.S. corporate tax code with nearly every other country and enthrall the possibility of corporations repatriating billions of dollars to the U.S. For years, drug and tech companies have stashed around 2 trillion dollars in profits in European banks to avoid taxes but a change in tax policy would allow them to bring that money home. A tax holiday would allow profits stashed overseas to come into our pockets as dividends and into our national economy as the government could invest in additional infrastructure with an added surplus. Corporations would also be able to invest their repatriated profits into plants and equipment which would create thousands of jobs.
Despite a political and volatile 2016 most project a continued bull market. The market experienced correction in August as the bull market reached a level of maturity and built-up excess subsided. Typically euphoria in investor behavior precedes bear markets but we have not seen evidence of that behavior as massive asset flows into bond funds suggest that investors are worried over equities. We are nowhere near euphoria but instead bouncing in between enthusiasm and panic as evidenced in recent volatility.
In a sea of volatility we seek to be your refuge for market insight and guidance. Fear tends to manifest itself much more quickly than euphoria or greed so volatile markets tend to be on the negative side. As the market begins to progress, fear and volatility gradually decline. In 2016 we are hoping for the market to progress its way beyond uncertainty and into prosperity. We will continue to seek to reduce risk and improve performance in the face of uncertainty. With a higher allocation in cash, your portfolio is poised to capitalize more as the market looks for stability in 2016.
As always, if you have any questions, inquiries, or concerns we are here to serve you.
Do you ever wonder where your drinking water comes from? Whether you use a filter or purchase a bottle straight from the mountains of Fiji, it comes from a water reserve. A water reserve can be regulated by dams, laws, and many other entities that account for fluctuations. The draught in California has caused water prices there to spike just as flooding could cause a price reduction. Water is a lot like money, you need both to live and both are regulated.
The Federal Reserve is the Lake Michigan of money. During times of economic hardships or drought, the reserve cuts interest rates which allows money to trickle down through the economy. The Fed is tasked with the large responsibility of not flooding the market with artificial growth but also not starving the market of economic opportunity. Just how Lake Michigan supplies countless other lakes and rivers with water, it is the Fed’s job to supply lending institutions with money. When the Federal Reserve raises the prime interest rate, it cost banks more money to borrow. Those costs are then transferred onto aspiring homebuyers, new businesses, builders, businesses thinking of expansion, aspiring automobile purchasers, and anyone who is seeking a loan.
The water level on Lake Michigan and the economy fluctuate. The last time the prime rate was changed was on December 16, 2008 and it was set at 3.25% where it currently stands. During the time of economic expansion in 2005-2007, the prime rate varied from 5.25% to 8.25%. Quantitative easing set in as the economy plunged in 2008 and the prime interest rate was set at a historically low level. The rate banks borrowed at just two days ago was the lowest since 1955.
10 Year History of the Prime Rate
Source: Federal Reserve Board, Proprietary Bank Surveys 2015
Wednesday, Janet Yellen and company unanimously approved a .25% rate hike. Your portfolio most likely experienced a bounce in an upward direction as we have been prepared for a rake hike for months. We planned on capitalizing off of a rake hike by adding positions in financials. Our strategy paid off and we foresee future gains as the financial sector is strong and additional rate hikes are likely to come. The market as a whole launched off as Wall Street celebrated Yellen’s decision to raise the interest rate in an accommodating and gradual manner. The move to raise the prime interest rate is symbolic of our recovery and a testament to the positive fundamentals of our economy that has us cautiously optimistic about 2016.
We are comforted by Yellen’s promise to raise the interest rate in the future in an accommodating manner but we remain vigilant. Thursday we experienced a pullback and there may be added volatility in the following week. Today the market plunged as options contracts expired and the oil forecast was worsened for 2016. Overall, this has been a volatile week for the S&P 500 but we finished almost where we started with nearly 8 points down at today’s close since Monday. As always, if you have any questions, inquiries, or concerns we are here to serve you.
Thank you for your continued trust and support.
The markets have been extraordinarily volatile and painful this week as we have closed in the red four days out of five. Investors find themselves in fear as terrorist attacks in France and California could happen anytime and anywhere and a federal interest rate decision is looming on the horizon of next week. On top of these matters, the presidential election in November will usher in a new era of national economic priorities and objectives. In an ocean of volatility, KFA seeks to be your vessel of calm and guide you to successfully reaching your goals.
No matter what Janet Yellen of the Federal Reserve decides on interest rate movement, the markets will be dissatisfied. A rate hike will potentially slow down growth and go against what every other central bank is doing. Not doing anything will cause the same dissatisfaction that came with the last Federal Reserve decision as many investors and media figures have been calling for a rate hike since October. If a decision is made next week for rates to go up, your portfolio stands to benefit as we have significantly increased our allocation in financials. We continually adjust our sails to put you in the best market position possible.
Author of Classical Economic Principles & the Wealth of Nations, Dr. Robert Genetski has increased his recommended stock exposure from 80% to 90%. This reflects mostly on the undervaluation of stock prices which he says are at least 21% below their fundamental value. Once the first rate hike since 2006 passes, Genetski projects a return to an upward trend. Against the backdrop of terrorism, interest rates, and an election this is what the majority of economists believe and hold firm to. All fundamental signs point to a 2016 that reflects what the market has done this year, no exceptional growth but nonetheless slow and steady growth. Although the current market driver is fear, we hold fast to our convictions in fundamental data that expresses long term growth.
This week, we reduced our bond allocation as bonds are in a disadvantageous position against an interest rate hike. Our role in the war on terror increased as we added an aerospace defense fund that we believe will outperform the market. We are always researching positions to reduce your portfolio’s volatility while maximizing your return. Our efforts have been concentrated on matters concerning year-end tax harvesting, tax strategy, and sustaining your portfolio growth. As always, should you have any questions or inquiries regarding your portfolio, taxes or experience a life changing event, please feel free to contact any member of the KFA Team.
Thank you for your continued trust and support.
(CNN Money, Fear and Greed Index)
In spite of largely unchanged market fundamentals, extreme volatility gripped the market this morning and is likely to persist this week. The DOW Jones saw an overall drop of 1,000 points within 10 minutes this morning. This morning appeared to be a market going mad, but NOT a US economy going bad.
Here is a snapshot of the time sequence that led to the DOW's market drop.
The first trades to drive down prices were automated trades induced by software algorithms, followed by trades to meet margin call requirements caused by lower prices. After this, we saw periods of selling as well as people buying in to find a good deal.
Stepping back to see what fundamentally changed in the course of the first ten minutes today we find nothing. There were zero new reports regarding the state of our economy. We have been concerned with the economic state of China which is why we have been selling positions over the past couple of months and are holding an unusually large cash position. We are watching closely to see if opportunities to buy present themselves or whether we continue to hold cash with our cautious stance. We will be watching to see how overseas markets perform overnight. Over the next several days we will be watching for signs of fundamental changes that may chart the course for the remainder of the year.
We will be listening to economic data reported later this week such as GDP estimates, pending and new home sales, and durable goods orders to name a few. Uncertainty still remains around a Fed rate hike as they have not set a date, saying it is data dependent. Although a large decline in stock prices alone does not mean the Fed will halt their plans to begin increasing rates.
We still hold a long term view for our current holdings and do not want to make irrational daily moves to lose sight of your long term goals.
As always, we appreciate your confidence and support in us. Please feel free to call should you have questions.
Your team at Kabarec Financial Advisors, Ltd.