The Standard & Poors 500 vs. The CBOE Volatility Index
Volatility Mad Dow disease is back, baby. The Dow Jones industrial average started the day with a bang, down 300 points. It then rose most of the day. The result: The Dow was down just 20 points by the end of the day. The Standard & Poors 500 was actually up slightly. What’s going on here? There’s plenty to be worried about. Let me list a few: The Housing Market, Greece, Tension in North and South Korea. Yet the market rallied. As you can see from the graph above, as bad as the market has felt, the drop in stocks (the blue line) recently has been no where near as big as the rise in volatility (the green line). It’s not clear where the market is headed next–up or down. But what is clear is that whatever direction we are headed, the captain has put on his fasten your seat belt sign. The stock market turbulence is actually a result of much bigger problems brewing than just the European debt crisis. So European bailout or not, big drops and jumps like today are here to stay. Here’s why:
So just how bad are the market jitters. The Volatility Index hit a high of 45 today. That’s actually higher than it was when Bear Stearns collapsed, or when Fannie and Freddie were taken over by the government. As you can see on The Big Picture’s excellent chart, it is around where it was at other scary times, like just after Sept. 11 or when the hedge fund Long Term Capital Management collapsed.
But the question is why are we so jittery. If your answer is the European debt crisis, stupid, then think about it. US banks and the US economy is far less tied to European debt than the collapse of a major investment bank or the mortgage market. So what is going on here. The real problem is that things that have traditional kept our market calm over the past few decades are all of a sudden missing.
#1 – The first big thing that we are missing is average investors. One of the things that you used to hear about the stock market is that it will always go up because individual investors are constantly dumping money into the stock market. Well that no longer appears to be the case. Most average investors have yet to jump back into the market since stocks started falling back in mid-2007. Mutual fund inflows never saw a strong increase after the market started to come back. Turns out individual accounts aren’t on autopilot as we assumed.
#2 – The second thing that seemed to keep the market calm in the 1990s and even in the post-dotcom bust era was this believe that even if the US had trouble, the global economy was headed for growth. Globalization was the cure. Even if American consumers busted out. Someone else would be able to buy. Emerging markets had billions of consumers just waiting to become Americanized and buy, buy, buy. Well that no longer seems the case. It appears that at least some of that emerging market strength, like our own, was based on over leverage. Some are concerned that China may be in a bubble as well. So Bye, bye global growth story.
#3 – Lastly, and perhaps most importantly, we have also lost the sense that stock deserve an equity premium. The thinking was always that equity grows faster than debt, and it’s a better long-term investment. Now that stocks have underperformed bonds over the past 40 years, the idea that stocks deserve some kind of premium valuation is hard to make. Here’s the WSJ running the valuations on stocks today:
As of the close of trading Monday, the S&P was priced at about 13.5 times estimated earnings of about $79.50 per share expected to be earned this year, according to Thomson Baseline. Using the same earnings estimate, the S&P is priced about about 13.3 Tuesday.
Given that the long-term average for the S&P is usually pegged at around 15 times expected earnings, things are looking a cheap, no? Is this a screaming buy sign?
Well, before you got on a buying binge consider these comments from Michael Shaoul, chief executive of boutique brokerage firm Oscar Gruss, who wrote Tuesday: “The current sell-off in U.S. equities has reached the point at which clear value is starting to appear,” he notes, adding later, “This is decidedly not the same as stating that a meaningful low in the SPX for the current move has been established and even deeper value may be created by the time this move is completed.”
The problem is, just like in the past, historic valuations are not a good measure. As I have noted here recently, there is a strong case to be made that stocks no longer deserve the valuation they used to get because they have become more volatile, and therefore risky.
For all of the reasons above stocks are worth less than we thought. The market is trying to determine just how much. And that’s going to take a while. That’s what the market’s volatility is really about, and why it is probably here to stay.