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Wednesday, January 24, 2007 4:40 PM

Dimes, Bulldozers, & Volatility

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Todd Harrison at Minyanville had some interesting thoughts about volatility today and I am pleased to be able to share them.

Here goes from Todd:

While I'm not the resident volatility expert in the 'Ville---that distinction belongs to the honorable Mr. Succo--I wanna further some thoughts that he's been discussing for some time.

Over the last few days, we've seen a very large seller of 5-year S&P puts. That's done two things: one, it put a bid to the market (the buyer of those puts must buy stocks as a hedge) and two--perhaps more importantly--it's depressed vols from already compressed levels.

The proliferation of "income funds" is a familiar topic to Minyans and, for us old schoolers, offering a sense of deja vu. I remember back during my Mother Morgan days, I had accounts selling "eighths" and "tinis" (1/8th's and 1/16th's) in size, collecting dimes in front of the bulldozer.

They made money for a few years, paving the way to a conditioned acceptance of this "free money" strategy. And then the bulldozer came in the form of a market decline, shutting most all of their doors.

This evolution--coupled with a distinct lack of hedging/protection--has vols, as measured by the VXO, at decade lows (which, ironically, was just about the time I left Morgan). And while part of the "vol crash" is a function of the sloshing liquidity (which is inversely related to volatility), there is a much more compelling story in our midst.

There aren't many of us left who remember what real volatility looks like. It is our hope that by reading the 'Ville, you'll be prepared for the squall when it arrives. For by the time you see it in the mainstream press, it'll be too late to proactively position yourself.
Thanks Toddo!

Here is a chart of the VXO to which Todd refers.
(Click on any chart in this post for a better view)

Perhaps volatility can go lower but it sure isn't going negative.

The appetite for risk is also shown in corporate bond yields. As long as yields keep compressing the stock market is likely to be firm. Following is the chart of Baa yields from Credit Swaps And Bond Yields.

Moody's Baa Bonds

Above chart by sharelynx.com.
Moody's Baa Bonds
Baa - Bonds and preferred stock which are rated Baa are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well.
Baa bonds are just one step above junk. Yields are close to 6%. You can get well over 5% on government backed CDs. Where is the risk reward?

Junk Spreads

The above chart is thanks to "orkrious" who posts on my board on Silicon Investor. The correlation is not perfect, nor is correlation the same as causation, but the stock market shows a tendency to sell off when yield spreads are widening. Note in particular the market selloff that started in May of this year just as spreads hit rock bottom.

These charts are not a sign of low risk but of a sign of willingness of investors to take nearly any risk to do better than the risk free returns on treasuries. Because of yield compression however, the size of the bets must increase to get the same actual returns. Think about that last sentence because it is part of what is driving insane increases in derivatives.

As yields compress the size of the bets (leverage) must increase to get the same returns. No one (especially me) knows when this is going to end, but betting on junk bonds, more yield compression, and/or betting on a further collapse in volatility is like picking up dimes in front of bulldozers.

Mike Shedlock / Mish

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