10.16.2014
By Terry Flanagan

Reading the Volatility Tea Leaves

The recent spike in market volatility has been attributed to a number of factors, including political tensions, uncertainty about monetary policy, and Ebola, but the biggest factor may be psychological, or the fear factor.

“When the market starts looking for a correction, it finds one whether it wants it or not,” Leon LaBrecque, CEO of LJPR, a wealth management firm that oversees $677 million. “The prediction of a correction by itself could be a self-fulfilling prophecy.”

LaBrecque describes the current situation as the ‘orange car’ syndrome. This is a psychological exercise that involves looking for orange-colored cars over a 48-hour period. Whereas they went unnoticed previously, all of a sudden they begin appearing everywhere. (LaBrecque saw 38 orange cars in a 48-hour period.)

“The last time we had a 10% decline in the S&P 500 was the third quarter of 2011, over 1,100 days ago,” said LaBrecque. “This is on a market that is up 189% off its 2009 lows. Many investors are waiting for the correction to buy. And maybe, if you look hard enough for a correction (or an orange car), you’ll find one.”

In a speech on Tuesday, Reserve Bank of Australia Assistant Governor Guy Debelle said, “Financial markets have been quiet, maybe too quiet, for much of this year. Of course, in saying this it increases the likelihood of it ending sooner rather than later.” Indeed, since drafting this speech, the VIX has risen to its highest level since February, and some market participants believe elevated volatility will persist for an extended period.

Heightened tensions in the Middle East and Eastern Europe, uncertainty about the turning point In U.S. monetary policy, a succession of strong U.S. job numbers, uncertainty about the future direction of policy in Europe and Japan, as well as increased concern about the strength of the Chinese economy, have all been present since the beginning of the year, but have failed to make a dent in volatility.

“There has been little reaction to any of the events,” said Debelle. “To the extent there has been any, it has been very short-lived.”

Although conventional wisdom holds that the low volatility that existed prior to last week reflects the forward guidance of central banks, which purportedly reduces uncertainty about the outlook for policy, this is not the case, said Debelle.

“Two-way volatility in interest rates has naturally been restricted as rates have moved towards the zero lower bound, but much of this effect has been present for some years now,” he said, “But more importantly in my view, while there is more forward guidance from central banks in place than in the past, investors don’t have to believe it. I find it somewhat surprising that the market is willing to accept the central banks at their word and not think so much for themselves.”

LJPR’s LaBrecque said the firm is in a “tactical position right now.”

“We just think that you have to be ready when the time comes,” he said. “In some ways, I’m sitting here going ‘You know, if this keeps going down, I’ve got an opportunity to get some bargains.’ On the other hand, if I just wait, it literally has been a really long time since we’ve had a correction.”

Featured image via Eisenhans/Dollar Photo Club

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