Volatility Lurks In One Hundred Caves

By: Michael Ashton | Wed, Nov 10, 2010
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With some markets closed tomorrow - pit trading of interest rates closed, electronic markets open, equity markets open, cash bond markets closed - the ones that are left open will be thin. Frankly, to me this seems to be part and parcel of building more tension. The 10y note has been in a range since early August, despite the fact that September and October are historically very strong months seasonally. The dollar has been in a range, although volatile within that range, since early October. Stocks haven't been in any kind of range for a while, but after clambering to resistance and achieving technical projections haven't really done very much to blast off to new frontiers.

There is no tension evinced by the VIX. With the election, QE2, and Employment in the rear-view mirror and a sparse event calendar given all of the holidays coming up, implied volatilities are soft and will stay that way until we have a meaningful move. But beneath the calm and unruffled surface of the duck, there is quite a bit of frenetic paddling going on if you peak beneath the surface. European bond markets continue to weaken; yesterday the Portuguese Finance Minister asked the EU for clarification on how the crisis mechanism would work in practice (link to the story is here), his comments helping to send the 10y Portuguese bond rate up 33bps to 6.91%. I can remember when 7% was a fairly generous rate, but it is now almost considered distressed! Greek bonds sold off 23bps (to 11.45%), Irish bonds declined for the 12th day in a row with the 10y yield at 8.48%.

And while the big events in the U.S. have passed, the effects of those events are all still in the future! Congress - that is, the lame-duck Congress - needs to pass legislation to fix the AMT and prevent the big January tax increases, and soon or it will be a real mess. The Fed has just started printing and at the same time, there are signs of a pulse (albeit a weak one) in some parts of the economy. Today Initial Claims improved to 435k; while it is hard to say definitively that the labor market is improving markedly the recent dribble lower in 'Claims does raise the question of whether the Fed is opening the sails too full to a following wind. (Still, it is difficult to say that Initial Claims are about to improve to the 325k level associated with even modest expansions - see the Chart below).

US Initial Jobless Claims

Claims better, but hardly great. Still, perhaps dipping below pre-Lehman levels finally?

And on the other hand, Cisco today guided revenues and earnings forecasts sharply lower after the close today. Cisco followed the usual fin-de-bubble practice of reporting better-than-expected earnings while guiding sharply lower for forward earnings and revenues. But this was pretty serious downward guidance: revenue this quarter of $10.1-10.3bln versus expectations for $11.1, and earnings of $0.35/sh compared to analyst dreams of $0.42. Ouch. That has smacked Cisco 15% lower in after-hours trading so far. I don't read it as a bellwether or anything like that. I just take it as a reminder that there is volatility lurking out there in one hundred caves, and we should be careful to avoid becoming careless just because it is sunny where we are. I am still waiting for a meaningful break one way or the other from these levels in equities before I make a decision on changing my allocation, but I must say I think the odds of a break lower in price - given these 100 dark caves full of potential baddies and the widespread bullishness seen in investor surveys - are greater than the odds of a break higher. However, I don't have to make an investing decision today; I can wait until things become a bit clearer. And so I will.


I enjoy anecdotes. Of course, we must be careful not to treat anecdotes as definitive evidence, in the sense that because A happened it implies that B must have happened. However, I think that anecdotes are useful in helping shape one's thinking. How does this event fit into my mental model of the world? A model that explains a large number of anecdotes is more likely to be useful than one which is perhaps purer in theory, but doesn't fit what we actually see.

That preliminary is meant as a justification for a short anecdote about government spending. Of course, most of us believe that the government spends far more of our money than we would like it to, but some people don't mind as much because they believe that most of the money is, at least, being directed by wise people in government who share our values (I am not claiming this as my own view, but I think it's a reasonable summary of how advocates of big government feel). If this is so, then it is difficult to explain the following anecdote as anything other than an odd exception.

Last week, I went with my wife to a Jazz at Lincoln Center Orchestra (JLCO) concert. I was thumbing through the inevitable program. I enjoy looking at the list of contributors at the back (it always amazes me how rich the Anonymous family must be). On this occasion, I noticed that the top tier of contributors to the JLCO ("Leaders") included the usual names: the Mellon Foundation, the Rockefeller Foundation, etc., but also included the United States Department of Education and the United States Department of State.

I can make a reasonable argument for why the Department of Education could plausibly give some support for the arts, although it is a mild stretch. But the State Department? Really? And doesn't the existence of contributions from two separate departments imply that no one really understands whose mandate it might fall under to make a contribution to Wynton Marsalis and his excellent orchestra? (Oh, by the way, the National Endowment for the Arts also made a contribution, which is to be expected. So make that three departments.)

One or two pages further, I note that contributors to Lincoln Center (generally) includes Lehman Brothers, who is a "Bravo Sustainer" at a contribution level of $1mm and above, and the Federal Highway Administration and Federal Transit Administration, at "Bravo Champion" level of $20mm and above. I don't see what Lincoln Center has to do with either highways or transit. There is a subway stop at Lincoln Center, but it has been there for many years and I am not sure why its presence would occasion a gift to Lincoln Center.

None of this has anything to do, in microcosm, with the markets. The question of whether the massive deficits we are running and the massive debt we are accumulating represents efficient spending which thereby contributes to long-term growth, however, is a reasonable question that gets to the heart of whether Keynesian stimulus should have a net positive effect in the long run. Of course, this is just an anecdote and we must be wary of mistaking it for evidence. I can't think of any other corroborating examples. Except for the U.S. Postal Service. Well, perhaps there are one or two more.

If government deficit spending is more productive than the alternate uses of the capital to which private industry would dedicate that money, then Keynesian stimulus is good in the short run because it stimulates demand, and pays for itself in the long run. If it is unproductive (or simply less productive than private spending), then whatever short-term stimulus it produces will be paid back in the future from an economy that produces less than it otherwise would...that is, it is a long-term negative. Nine stitches instead of the one in time. (This is not strictly true; if Keynesian stimulus is borrowed and the money is spent on projects that return at least the cost of interest, and it never needs to be paid back so that the aggregate leverage of the economy is permanently increased with no private spending being crowded out, then it may be the case that Keynesian stimulus is productive in the long run. We have seen, though, that most of these assumptions are provably false).



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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