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Volatility Index Points to Bubble Creation

Posted by Steve Markowitz on March 12, 2013

VixA useful chart in understanding the mood of investors is the Volatility Index referred to as the VIX.  This Index is the “fear gauge” for equity markets.  The higher the VIX rating the greater the fear.  As indicated by the chart, the fear index is at historic lows.  It is therefore not surprising that equities’ values are the highest they have been since the economic meltdown began over four years ago.

In a “normal” economic environment, high equity valuations generally indicate a positive economy, suggesting strong business fundamentals.  Given the length of the current economic turmoil there is something else at play.  The culprit or benefactor, depending on one’s perspective, is the Federal Reserve and its policy of continuing to keep interest rates artificially low.

With returns on safe investments near zero, investors are looking for increased yields and this is resulting in increasing equity and commodity prices, i.e. more risky investments.  This is a sure sign of bubble creation, precisely what the Fed desires.

With onset of the financial meltdown, the Fed decided to offset the economic downturn by printing money that when circulated increases asset values.  While this led to some positive effects in the short run, when bubbles pop, and they always do, the results are very unpleasant, as we learned with the housing market.

How far has the VIX moved?  As the 2008 financial crisis unfolded this index hit 80.  It is currently at about 12.  Imprudent financial decisions are made by investors when the index is at the fringes.  Supporting this conclusion is JPMorgan’s speculative position indicator that concludes investors are taking on the most risk since the third quarter of 2007, just prior to the meltdown.  In addition, with cheap money availability, investors are increasing the usage of leverage, another problematic tool when bubbles are created.

Potential bubbles are not only showing up in US equities’ markets.  The Fed’s policies have incentivized bubble creation throughout the world including other stock markets and Chinese real estate.  Given the inter-dependence between world markets, a collapse of any of these bubbles is problematic on an international basis.

Some well-respected financial experts are offering warnings on asset inflation and the potential for large market corrections (bubbles bursting).  PIMCO’s Bill Gross, perhaps the most respected bond expert in the world, offers caution stating:

“Yet the common sense of John Law – and likewise that of Ben Bernanke – must have known that only air comes for free and is “essentially costless.”  The future price tag of printing six trillion dollars’ worth of checks comes in the form of inflation and devaluation of currencies either relative to each other, or to commodities in less limitless supply such as oil or gold.  To date, central banks have been willing to accept that cost – nay – have even encouraged it.”

US equity markets have had a great run.  However, such events often convince people that we are in a new economic paradigm and that the market will continue to go up.  While it is possible that there remains upside, downsides are often not seen until it is too late.  Prudent investors would do well to listen to experts like Bill Gross.

 

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