Low volatility points to some big moves in investment markets! (page 1 of 2)

Financial pundits also expect these moves in the financial markets to be likely on the downside. And while I tend to agree that volatility will sooner or later rise, an increase in volatility does by itself not necessarily imply that rising volatility will lead to market sell-offs.

As an example, extremely low volatility in the bond market gave, in early 1987, way to a sharp sell off in bond prices and a rise in long term bond yields from 7.14% to 10.23% (bond prices bottomed out a week before the October 19th stock market crash).

Conversely, low volatility in April 1998, was followed by a sharp rise in bond prices. 10-year government bond yields fell from 7.11% to 4.11% and bottomed out, in September 1998, in the wake of the LTCM crisis.

So, all low volatility is suggesting is that a "big move" is coming but it does not convey the direction of the next big move. Now, in the case of the stock markets around the world we have record low volatility and in the case of the US, the VIX volatility Index is hovering near a ten years' low.

In fact world equity implied volatility is at present far below the average volatility of the last 10 years. So, all we can say is that within the next few months a large stock market move can be expected, either up or down.

But the question is obviously whether an upward or downward move in stock and bond markets is more likely. For equities, most indicators do seem to suggest that the next big move will be on the downside.

Financial institutions have a record low level of cash hence there is little buying power left. Insiders continue to sell heavily. The public and fund managers are very bullish about the prospects of equities - a contrary indicator, which would rather point to a sell-off in equities.

Liquidity tightening

Moreover, global liquidity has been tightening. Earlier in the year, I showed that money supply growth had been decelerating. My friends at Gavekal Research compile a global monetary indicator that suggests tighter global liquidity, which is usually not very favorable for investment markets.

In the eyes of the American Federal Reserve the US economy appears to be sound (it is not - just look at GM) and, therefore, the Fed is likely to continue to raise short term interest rates - that is unless the US economy weakens suddenly once again badly.

Therefore, we should assume higher short term interest rates and tighter liquidity for the foreseeable future, which should not be good for equities.

Admittedly, the S&P made a new recovery high in the first week of March, but strength was concentrated in energy and basic material stocks while financial shares are underperforming. Usually, when financial stocks are under-performing while oils are strong the market is in the last stage of a bull market.

In addition, stock markets appear to be - after their recent renewed strength - to be overbought. This would especially apply to emerging markets, some of which had almost vertical upward moves. At the same time corporate bond spreads are at record low, suggesting widespread complacency about risk.

So all in all, as far as stock markets are concerned it is more likely that rising volatility will give way to possibly severe market downward moves.

For bonds the picture is murkier, since bullish sentiment on bonds is rather leaning on the bearish side. Still, bonds would seem to be vulnerable as either economic growth could surprise on the upside or as "visible" inflation accelerates.