Review of the week: Comeback king

American stocks roared back from last year’s setback at a pace rarely seen. Our chief investment officer, Julian Chillingworth, puzzles over the diabolical VIX index and explains why he thinks markets could be getting ahead of themselves.

The S&P 500 completed one of the most glorious snap-backs in the history of markets last week.

After hitting a record high on 20 September, the benchmark US stock market index slumped almost 20%, bottoming out in late December. It has since rocketed back, taking just 146 trading days to slump and then recover its losses. It posted a new all-time high of 2,939.9 on Friday. But, most intriguingly of all – to us at least – is that this massive slingshot market move was accompanied by a falling VIX volatility index. The VIX stood at 13 on Friday; its long-term average is around 20. You would think large swings in the S&P would increase the volatility index, not drive it lower. However, the VIX is like the weather: it is talked about more often that it is actually understood.

The VIX is a very complicated beast. It is calculated by cramming the prices of options to buy and sell the S&P 500 (and how much those prices move around) through a formula that would bring most people to tears. Also, the VIX tells you the implied volatility of the S&P, i.e. what investors expect it to be, not what it actually is. There are a few lessons to take from this. Firstly, never trust the market to turn out how most people expect! Secondly, if the VIX is based on options, it will be affected by demand and supply of those options. Whether that’s fund managers buying lots of put options to protect their equities should markets tank, or perhaps selling call options to get more income in a low-interest-rate world, it will have an effect on the VIX.

And then there are the hedge funds. As of last week, these risk-loving cowboys were net short (betting that something will go down rather than up) the VIX index by about 178,000 contracts. That’s the largest bet on the VIX falling since the numbers were first collected in 2004. But again, there may be more to this than meets the eye. It may not be that investors are ‘betting that volatility will go even lower’ or that they are ‘picking up pennies in front of a steamroller’. Much of the time, options are used to manage risks in portfolios, to reduce your exposure to equities when prices are looking high or perhaps to ‘synthetically’ increase your holdings when prices look too low. A lot of options trading is done by large investment banks to offset trades and products they create for clients. These banks aren’t betting on anything, they are simply making sure they have locked in a profit that won’t be affected by market swings. Structured products – which have become extremely popular in recent years – are simply options wrapped up with bonds and sold as tasty high-income investments for everyone from retail investors to professional fund managers.

Sometimes, when everyone does what appears best for them it can look a bit disjointed in the aggregate.


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Source: FE Analytics, data sterling total return to 26 April

Moving with the music

So, ‘melt-up’ time? A melt-up is when equities move swiftly higher as ever-increasing numbers of investors buy into a stock market to benefit from the upward momentum. In English, everything is going up and the excitement attracts more and more people who in turn push prices up more and attract ever more people. It sounds a lot like the definition of a bubble, but it’s not quite that. Well, so say the people who coined the term – but stockbrokers would say that, wouldn’t they.

All I know, is that when you see your verging-on-communist art teacher friend boosting a mobile investing app on Facebook, you can probably be sure that stock market participation is getting pretty widespread. Don’t get me wrong, I’m not preaching doom and disaster here, I’m just noting that the market has swung back at a whiplash-inducing speed and not all that much has changed. It seems like many professional investors are hoping that the US Federal Reserve (Fed) has become so worried about strangling the economic recovery that it may even cut interest rates sometime this year. And more than a few amateur investors appear to have been enticed to get in on the action too.

The idea that the Fed will cut interest rates seems a bit farfetched to us, so markets could bleed away if this decrease in rates never materialises. Although the chances of several rate hikes seem slim too, and that should help support both the economy and global stock markets.

At bottom, we still believe recession is unlikely this year. And that means equities are the best place to be for now. First-quarter US GDP growth surprised virtually everyone last week coming in at 3.2% annualised; just 2.3% was expected. But beneath the surface the picture wasn’t all roses. Much of the expansion came from businesses increasing the stock in their warehouses, not typically a great sign at this point of the boom-bust cycle, and private investment and consumption were markedly lower. Net exports were higher, which is helpful for the US given its large government deficits.

US CPI inflation picked up last month to 1.9%, but the latest Core PCE measure (for January, because of the government shutdown) – which the Fed prefers – actually decelerated to 1.3%. All eyes will be on the Fed when it meets on Tuesday and Wednesday. No change to its policy is expected this week, but investors will be very interested in the Fed’s forecasts for growth and inflation because they will inform whether the central bank will raise, cut or simply leave interest rates where they are.

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