The VIX – Too Quiet?

The financial media’s approach to the fiscal cliff story was about as subtle as a herd of elephants. Every day we were bashed over the head with the dire consequences that would befall our nation the very moment we hit January 1st. Never mind that it wasn’t true – it made a good story, and doomsaying is tried and true method of boosting ratings.

But for all the media’s efforts, the “market” was about as scared as Felix Baumgartner is of heights… not very.  In the days before the deal was finally reached, we saw a modest spike in the CBOE’s volatility index – the VIX, but overall the amount of fear as measured by the so called “fear index” was essentially nonexistent.

With the fiscal cliff in the rear view mirror, we’re now approaching the debt ceiling – and this time around an apocalyptic hysteria might actually be justified. Unlike the fiscal cliff, any debt ceiling shenanigans which result in the US not paying some of its debts on time could have immediate impact.  Casting doubt on the reliability of US debt is not something easily erased, and there are far more ways this legislative showdown could go wrong than go right.

And how has the VIX responded to this possibility?  It’s about as scared Baumgartner on the Dumbo ride at Disney, dropping to its lowest level since June 2007.

Disclaimer: past performance is not necessarily indicative of future results.

So what’s going on? How can the VIX be so low when there’s so much that could still go wrong? Is everyone really convinced that Congress is going to behave like adults and solve this before we’ve irreparably damaged the United States’ credibility? Do they think that the Obama administration is bluffing about their unwillingness to use the 14th amendment or the trillion dollar coin to avert disaster at the last minute? Is this a case of partying until the lights go out?

Or, have we just been “crisised” out? There are still several weeks left for the financial media to get their hysteria machine up and running, and for the VIX to increase to levels that make more sense in the shadow of such a crisis.

All we know is that volatility expansion tends to come out of periods of low volatility like we’re seeing now – a sort of calm before the storm; so the lower it goes and the more people ignore looming crises, so much the better for long volatility loving managed futures which should benefit from its eventual move higher. Of course, sooner rather than later would sure be nice.

The Fiscal Swerve?

Leading up to New Year’s Eve, there was much ado about nothing the January 1st deadline for striking a deal on the fiscal cliff. Congress, dysfunctional and frequently misguided though they are, knew better. Yes, the economic consequences were going to be dire in the long run had a deal not been hammered out, but to hear the media talk about it, one would have thought that U.S. GDP would have been immediately decimated. In reality, the projections being passed around as disaster porn would have played out over the course of a year or longer, and Congress knew it. No, January 1st didn’t matter, and neither did those projections. Congress just needed to pass a deal prior to the markets opening today in order to prevent a -3% or greater risk off drop that would have backed them into a corner where political capital losses would have been even more steep. Fortunately for them, as the Washington Post reports, a deal was finally struck in the 11th hour:

Congress approved a plan to end Washington’s long drama over the “fiscal cliff” late Tuesday after House Republicans surrendered to President Obama’s demand to let taxes rise on the nation’s richest households.

The House voted 257 to 167 to send the measure to Obama for his signature; the vote came less than 24 hours after the Senate overwhelmingly approved the legislation.

Good news to be sure, and the markets are breathing a sigh of relief:

Source: Disclaimer: past performance is not necessarily indicative of future results.

So what did this magical deal look like?  The Washington Post continued (emphasis ours):

The bill will indeed shield millions of middle-class taxpayers from tax increases set to take effect this month. But it also will let rates rise on wages and investment profits for households pulling in more than $450,000 a year, marking the first time in more than two decades that a broad tax increase has been approved with GOP support.

The measure also will keep benefits flowing to 2 million unemployed workers on the verge of losing their federal checks. And it will delay for two months automatic cuts to the Pentagon and other agencies that had been set to take effect Wednesday.

In other words, the bill was, in many ways, a cop-out. Decisions were not made on the bigger issues; they were deferred. Discontent on the hill over the way negotiations played out is incredibly high. While the 113th Congress will tackle the delayed issues, much of the Congressional leadership will remain in place, and they’re in no mood to play nice. As Politico reported:

House Speaker John Boehner couldn’t hold back when he spotted Senate Majority Leader Harry Reid in the White House lobby last Friday.

It was only a few days before the nation would go over the fiscal cliff, no bipartisan agreement was in sight, and Reid had just publicly accused Boehner of running a “dictatorship” in the House and caring more about holding onto his gavel than striking a deal.

“Go f— yourself,” Boehner sniped as he pointed his finger at Reid, according to multiple sources present.

Reid, a bit startled, replied: “What are you talking about?”

Boehner repeated: “Go f— yourself.”

The harsh exchange just a few steps from the Oval Office — which Boehner later bragged about to fellow Republicans — was only one episode in nearly two months of high-stakes negotiations laced with distrust, miscommunication, false starts and yelling matches as Washington struggled to ward off $500 billion in tax hikes and spending cuts.

Happy new year? We’ll have to wait and see. Hopefully tempers won’t be running so high a month or so from now… or we could be back in the exact same spot.

Ten, Nine, Eight, Seven…

President Obama took to the podium today to discuss the status of Congress’ efforts to avert the self-created crisis known as the fiscal cliff. Unsurprisingly, he confirmed that there will be no grand bargain – that is, they aren’t going to attempt to deal with either long term spending or the debt ceiling in this package. Far from being the last installment of Congressional gridlock over a manufactured crisis, it seems almost certain now that we’re going to be rerunning this drama again in the coming years (especially if the polarization of Congress continues as it has recently).

But Obama did sound positive that a deal on taxes had been reached to let rates rise for higher-income Americans while keeping them flat for everyone else (in turn sending stocks higher and bonds lower) After Boehner made it clear that the Republicans would accept an increase in the tax rate, it essentially became a question not of if, but of how much. Business Insider has a breakdown on how that tax deal is shaping up.

The sequestration still needs to be taken care of, and on this Obama implied that there’s still a fair bit of work to be done. Deciding what to cut and how much was always going to be tough – few things enrage voters as much as seeing their favorite social programs slashed. But it appears that, with no more time to kick the can down the road, the threat of the cliff has finally elicited some action from Congress. Perhaps we’ll find out exactly what that means before the night is over.

Tonight when revelers are counting down from ten, it might not be a part of their New Year festivities – they may be counting the seconds until Congress finalizes the details of the fiscal cliff deal.

The real question for managed futures is what happens when the hangover cures and markets get back to business on Jan 2nd. A failure to reach a deal and big sell off would be just what the doctor ordered for the asset class, which will put in its third losing year in the past 4 after closing out 2012 today. Here’s to better times (for managed futures) ahead.

Careening Over the Dairy Cliff

In case all that fear mongering and minute-by-by minute obsessing over the fiscal cliff hasn’t sated your desire for hyperbole and manufactured crisis, you’ll be happy to know that the “cliff” meme is spilling over into other areas, too. The Congressional gridlock we all know and love has prevented our legislators from addressing the expiring farm bill, which could be seriously bad news for any dairy fans out there. Via CNN Money:

Problem is, the current bill expired last summer, and Congress had been unable to agree on a new one. Several protections for farmers have already expired, and several more are set to do so over the next few months. One of them is the dairy subsidy, which expires January 1.

But instead of leaving farmers entirely out in the cold, the law states that if a new bill isn’t passed or the current one extended, the formula for calculating the price the government pays for dairy products reverts back to a 1949 statute. Under that formula, the government would be forced to buy milk at twice today’s price — driving up the cost for everyone.

Milk futures are bought and sold both electronically and in the pits, although they tend to be very thinly traded. So far in December the average daily volume for the front month class III milk contract has been under 300 and the average daily open interest just over 3000. That’s less than a rounding error compared to the heavily traded S&P 500 e-mini contract, which has consistently had around 2.5 million in volume and open interest during the same period. Even so, the handful of milk traders out there don’t seem to be too worried about this particular cliff:

Disclaimer: past performance is not necessarily indicative of future results.

Considering that the dairy cliff would be incredibly expensive for the US government, for US citizens, and even has the dairy industry worried (since it would almost certainly reduce milk consumption), this seems like a no-brainer. Call us hopeless optimists, but this looks like one item that even the US Congress ought to be able to deal with…

P.S. If you’re wondering why the chart for milk futures is in the $17-$19 range, it’s because each contract represents 200,000 pounds of milk, and each $0.01 tick represents $20.

Managed Futures and the Fiscal Cliff

As the 24-hour news cycle finishes squeezing the last drops of interest from the election, the next “big story” was determined long ago: the fiscal cliff. It’s hard to read anything on the financial web without at least seeing a passing mention, if not a series of articles dedicated to the looming budget debate it represents. And we’re still 46 days away from the end of the year.

But in our corner of the financial world, the fiscal cliff holds a somewhat different meaning. Managed futures, as we often say, doesn’t care whether the markets are moving up or down – it’s the character of the move that determines whether CTAs prosper or muddle through. So regardless of whether we see a “grand compromise,” a temporary stopgap, or go past the deadline with no deal struck, managed futures may reap the benefits… or suffer the consequences.

Specifically, for the trend followers that make up the bulk of the industry (and who have been struggling lately), the worse-case scenario would be any outcome that leads to a short trend followed by a quick reversal. For example, if the deadline passes with no deal and all sorts of risk on markets take a dive, only to be resuscitated by a 13th-hour compromise that sends those markets shooting back into the green, trend followers could get caught in the whipsaw for losses.

However, if a deal passes over the next few weeks and the market loves it (or hates it), leading to a prolonged rise (or fall) in risk on/risk off markets… trend followers could get just the market conditions they’ve been wishing for.

Like everyone else, there’s little we can do other than anxiously watch events unfold. But unlike the “buy, hold, and hope” crowd, we at least feel a little better knowing that it isn’t a binary event for managed futures – who don’t need a resolution and higher stock market prices to succeed. And speaking of those buy and hold types, if you haven’t prepared your portfolio for the possibility of losses due to the fiscal cliff, don’t come complaining. This crisis has been about as high speed as the  Euro area problems were, meaning you’ve only had 6-12 months to prepare.

No Brakes Ahead of the Fiscal Cliff

Say what you will about Bernanke, but if this whole central bank gig doesn’t work out, he might have a future in writing catch phrases. Ever since he used the phrase “fiscal cliff” to describe the combination of tax hikes and spending cuts that will automatically kick in unless Congress acts by the end of the year, it’s rapidly become a household term (at least in our households). Judging by Google search traffic for the term, we’re not alone:

Fiscal Cliff Google search trends

It also happens to be the perfect encapsulation of the collective fear for the future of the US economy – that we’re careening toward disaster.

At least, that’s been the dominant narrative over the past few months. But talk, as they say, is cheap. When it comes to actual behavior, we’re just not seeing as much as we expected of investors or companies bracing for impact. Stocks are at or near 2012 highs, and hiring trends have been positive, if tepid. Via Bloomberg:

A pullback in business investment had fanned concerns that companies would begin to pare hiring in anticipation of $600 billion in government spending cuts and tax increases at the start of 2013. The Congressional Budget Office has warned the economy will fall into recession if Congress allows the fiscal squeeze to go ahead.

The jobs numbers suggest the economy is expanding at a “trend-like pace” of around 2 percent, Kasman said. That would be in line with the 2.2 percent average quarterly growth rate of gross domestic product since the 18-month recession ended in June 2009.

Obviously, going over the fiscal cliff is not a certainty – Congress could always step up and pass a “grand bargain” to avoid the automatic cuts. It’s just that, well, given the dysfunction in DC over the last few years, we’re surprised that any Americans are willing to bank on an 11th hour compromise. Beyond the hiring figures, there may be some indication that businesses are concerned:

“Uncertainty around the fiscal cliff has already caused firms to postpone capital-goods orders,” Joshua Dennerlein, U.S. economist for Bank of America Corp. in New York, said in a note after the release of the jobs numbers.

Shipments of nondefense capital equipment excluding airplanes, a proxy for business investment, fell 0.9 percent in August after decreasing 1.1 percent in July, according to Commerce Department figures.

But overall, it looks like the fiscal cliff is not yet being treated as a likely outcome. Whether that will change once zero hour draws near remains to be seen.

Bucking Vacuum Mentality

Traditionally, when you read a story, the moral comes at the end – a sound bite takeaway that justifies the time spent. We’re going to try something a little different, though, and provide the moral of the story up front. See, this story has a lot of moving pieces, and it can be all too easy to focus on one point, missing the forest for the trees. So before you even get started here, remember:

Nothing happens in a vacuum.

Chaos has erupted in the Middle East, and there’s no easy way to stem the tide. In Afghanistan, terrorists disguised in U.S. uniforms infiltrated our military bases, resulting in suspended joint operations that inevitably extend the conflict. In Libya, premeditated attacks resulted in the death of a U.S. ambassador. Anti-western sentiment has fueled protests in 20 separate nations. In Syria, what started as a small uprising is now full-blown civil war, with various actors in the region providing weapons and support to the rebels. Iran has shown renewed defiance in the face of international pressure regarding their nuclear program, repeating threats of wiping Israel off the face of the map, and the U.S. has begun to ramp up their language about consequences.

This kind of unrest and violence has the potential to upend an already volatile region, and that’s putting it lightly. With so much uncertainty, one would typically expect oil to be surging to new highs, yet oil today dips below $90 a barrel.

Nothing happens in a vacuum.

Yes, the violence and uncertainty in the Middle East may present concerns about supply, but there are serious questions about global consumption in the coming months and years, and with good reason.

For a very brief, beautiful window of time, it appeared as though we might be done talking about the Euro Crisis. After months upon months of turbulent debate over how best to stabilize the economies in the region, leadership announced a bold bond buying program, spearheaded by the ECB, and a reticent Germany was likely to provide support, however tepid. The markets, finally, had stopped responding to every little rumor on the continent as though they had mood altering drugs being piped in through a direct line.

Those were the days! Well, maybe “the minutes.”

The thing is, the discussion of these Euro Crisis solutions, how they might be implemented, and what their impact would be, took place in a very controlled environment. The markets held onto the belief that leadership would ultimately do whatever necessary to fix the situation, regardless of how many ups and downs came in between. After all, if individual banks could be considered too big to fail, surely the economies of entire nations qualified for the same sort of consideration.

And in some ways, such expectations make sense. If you look at the big picture, analyzing economic realities from a distance, such decisions were, of course, inevitable, with austerity-conditioned aid a near certainty.  Political leadership would have to make decisions rationally, and in that case, the ending was predetermined. Except, such calculus ignored the one element that never depended on what is rational for everyone:

The people.

Austerity measures, on paper, merely represent a number in an equation, but for the people the austerity measures impact, that couldn’t be further from the truth. A budget cut in some of these nations could be the difference between employment and the bread line; between a roof over your head or a box in the street; between dignity and despair. With economically driven suicide rates on the rise across Europe, this isn’t about what’s rational in the long run or the big picture; it’s about what comes tomorrow.

So are the scenes we see rolling across our screens really all that surprising? In Greece, what started as a general strike has transformed into violent riots, where protestors hurl petrol bombs at police forces. In Spain, as leadership attempts to pen austerity proposals, thousands of protestors surround cops sent to control the masses. They say a picture is worth a thousand words…

… but even that doesn’t tell the whole story. While the violent images are a jarring reminder of why we can’t assume a rational decision making paradigm on these important issues, it’s not the only complication in this crisis. While protests erupt in Spain and Greece, Portugal is looking more like Greece by the day. Italy’s economy continues to contract, as the population feels the pain of austerity measures coming into effect without additional aid. France is far from strong, and even Germany – often regarded as the last, best hope for Europe – is seeing their economy start to soften. Commitment to maintaining the Euro Zone, while admirable in principle, almost guarantees more pain to come.

And nothing happens in a vacuum.

Europe is in crisis; there’s no denying that. But Europe isn’t the Alpha and Omega of the global economy, which brings us to the BRIC nations. Brazil, Russia, India and China may have been given the nod by Goldman Sachs 11 years ago, but today, their prospects for ongoing growth appear dismal. Inflation is plaguing the countries, with Brazil seeing consumer prices jump 5.2% in July, Russia 5.6%, and India a whopping 9.86% headed into Monsoon season after record drought conditions. China came it at much slower increase of 1.8%, but they’re not out of the woods, as they stare down their 9th straight quarter of economic slowdown, with their stock market plummeting to 2009 lows.

And this is just what we know. As the New York Times reported earlier this year, there are major concerns about the validity of data coming out of China – arguably the most important of the BRIC economies:

As the Chinese economy continues to sputter, prominent corporate executives in China and Western economists say there is evidence that local and provincial officials are falsifying economic statistics to disguise the true depth of the troubles.

Record-setting mountains of excess coal have accumulated at the country’s biggest storage areas because power plants are burning less coal in the face of tumbling electricity demand. But local and provincial government officials have forced plant managers not to report to Beijing the full extent of the slowdown, power sector executives said.

Electricity production and consumption have been considered a telltale sign of a wide variety of economic activity. They are widely viewed by foreign investors and even some Chinese officials as the gold standard for measuring what is really happening in the country’s economy, because the gathering and reporting of data in China is not considered as reliable as it is in many countries.

Indeed, officials in some cities and provinces are also overstating economic output, corporate revenue, corporate profits and tax receipts, the corporate executives and economists said. The officials do so by urging businesses to keep separate sets of books, showing improving business results and tax payments that do not exist.

The executives and economists roughly estimated that the effect of the inaccurate statistics was to falsely inflate a variety of economic indicators by 1 or 2 percentage points. That may be enough to make very bad economic news look merely bad.

This type of economic concern is shadowed by several years of highly publicized fraud in the private sector (Sino Forest, anyone?) in a heavily controlled information flow, leaving us to wonder what lies beneath the surface. In Russia, other vulnerabilities persist. As Reuters reports:

A lending spree by Russian banks may be piling up problems for the sector in future, especially if a sharp fall in oil prices puts a stop on the country’s economic growth, a senior central bank official warned on Tuesday. […]

Recent stress tests by the central bank show the number of domestic lenders that could face capital shortfalls under an “extreme” scenario – where a drop in oil prices drags down the economy – has risen 2.5 times since earlier this year, he said.

A sharp fall in oil prices? Poorly prepared banks with too much debt on the books? Sound familiar? There’s a lot of weakness in these regions- regions where consumer habits and juggernaut growth have been viewed as a safety net for the global economy.

And nothing happens in a vacuum.

In an election season saturated with economic laments, how ironic that the U.S. looks strong by comparison. Stocks are up over 95% since 2009, home sales are finally on what looks like a firm road to recovery, and consumer sentiment is soaring upward. But at the same time, unemployment is at 8.3%, and debate over how to buoy the job market is running hot. Still, those debates are taking place in the dreaded vacuum – with solutions and efficacy being placed squarely on the shoulders of the presidency, and perhaps, as Josh Brown explains, in a place far, far away from reality:

Which brings me to the US equity markets, which are coming off of a virtually uninterrupted melt-up since the end of June, with virtually every sector and stock participating regardless of economic sensitivity.  This in the face of eroding fundamentals for many bellwether stocks and industry groups, Fedex and Caterpillar being just the latest examples to tell us how lousy things are.

But we ignored the fundamentals and rampaged higher on sentiment. This is how you explain a stock market that runs up 15% with no change in earnings estimates for the forward two quarters. The improvement in sentiment – driven by the assumption and then confirmation of permanent Fed support – is responsible for virtually all of your portfolio’s gains since the Summer Solstice, no offense to the regard with which you hold your stock-picking abilities.  Even the most bullish strategists with the highest year-end S&P targets acknowledged that multiple expansion was the key ingredient for their forecasts, none of them were looking for an acceleration in fundamentals by year-end.

In short, we built a Castle on a Cloud, the accumulated moisture of performance-chasing and confidence were its only foundation. And now, with European markets back in turmoil – with all of the volatility and drama that brings – the only question is whether or not our Castle on a Cloud can remain aloft, above the disturbances at ground level.

That’s the thing about Castles on Clouds – a surrounding siege army is not required for them to fall, only a change in air current that dissipates the molecules.

But what on earth could change that air current? Setting aside the first thousand words here, there’s this little thing called the Fiscal Cliff. As a reminder, the Cliff references a combination of events that would play out over November and December of this year. With a redux of last August’s debt ceiling debate coming around, the lame duck Congress will also be trying desperately to avoid a series of tax cut expirations and scheduled spending slashes set to take effect on the first of the year – the cumulative impact of which is the shrinking of the economy and exacerbation of current pains. With Republicans firmly opposed to any form of tax increase, Democrats unwilling to cut spending without some offsetting revenue, and their “Do Nothing Congress” moniker based on a partisan gridlock without comparison, a change in the current isn’t all that hard to envision.

And nothing happens in a vacuum.

In his United Nations address yesterday, President Obama referenced the impact of technology on the connectivity of message and audience, but it’s not just the stories we tell that connect us. The best example of the shared narrative- the “common heartbeat to humanity”- is how synced up our economic heartbeat has become. Call it a castle on a cloud, house of cards, or personified Bon Jovi lyric, but things are far from stable or sustainable right now, particularly in a world where we delude ourselves into thinking all of these things happen in a vacuum and can be addressed in the same manner.

If you’re not thinking in a vacuum, portfolio diversification becomes more important than ever. But it’s not enough to pay diversification lip service with traditional allocation strategies – you have to make sure you have truly non-correlated exposure backing you up. We don’t make a secret of which asset class we think best fits the bill… and we’re more than happy to discuss options.