During the past month, the markets have seen severe volatility and it’s been affecting many traders and investors. The tone during the last few weeks has been fear and panic. Investors and traders have lost their appetite for risk.
Given the volatility the market has experienced in the last month, it’s no wonder that people are seeking safety. The Chicago Board of Options Exchange market’s Volatility Index (VIX), also known as the “Fear Index,” has been at record highs. The VIX is calculated from both calls and puts on the S&P 500 index options. Basically, it shows the market’s expectation of volatility in the next 30-days.
The severe volatility has affected not only financials, but also commodities. Many commodities were cut in half in a matter of months. Corn was near $8 a bushel this past June, and is now near $4. Soybeans were at $16 a bushel, and now are near $8. Crude oil was near $150 a barrel, and now trades near $70. Most commodities have taken a hit.
Equities have also taken a beating. The S&P 500 is down about 40 percent this year. The stock market conditions seem like a severe storm. Imagine you’re in the water getting hit by wave after wave and you’re gasping for air. And right when you think it’s alright to start breathing normally, you get hit by another big wave. At this point, many investors and traders are just looking to survive.
The markets have been so volatile, that the S&P 500 can move four or five points before you finish entering an order. It’s been vicious. Fifty to 60-point ranges in the S&P 500 have become more common.
New Economic Worries
Let’s go back six months. What was the worry? The worry was subprime. The housing market was one year into its problems. Now we’re seeing the credit markets getting tight. Banks stopped lending to each other. The stock market dropped sharply. Consumer confidence and spending have plunged. Now a recession has become a very likely possibility.
The Federal Reserve and the Treasury Department have intervened to stop the bleeding, but markets have yet to respond. Six months ago, some thought that a recession in the U.S. wouldn’t have a drastic impact on other world markets, but that theory has definitely been debunked. I’ve said it before, and it’s been commonly known: when the U.S. sneezes, the world catches a cold.
In the last two or three weeks the stock market has lost about 20 percent. Just three weeks ago, Treasury Secretary Henry Paulson came before Congress and suggested a $700 billion bailout package to save the markets. A modified version of this plan was passed, but the market hasn’t responded. Some argue it will take time and others argue it will prolong the problems. The fact of the matter is that it hasn’t restored confidence. Investors are still fearful.
The word on the street has been that the credit markets are now beginning to “thaw” from their previously frozen state. When the credit markets freeze, unemployment goes up. Small businesses no longer have access to capital they need banks to lend them. This puts pressure on businesses to scale back. Many businesses rely on short-term borrowing to finance their payrolls. When that financing dries up, businesses run into cash flow problems. The quickest way to ease these problems is to lay off workers.
During the last two weeks, we’ve seen a deterioration of the stock market and commodities market. We’ve also seen a contraction in manufacturing and retailing. The consumer is the bloodline of our gross domestic product (GDP), making up nearly three quarters of it by some estimates. So if the consumer stops spending, the economy will fall into a prolonged recession. It’s as simple as that.
In early October, in just one week, the S&P 500 collapsed about 20 percent. This was about 1,000 points in the Dow Jones Industrial Average. In just two months, the S&P 500 has gone from 1294 on August 25 to near 869 on October 24. If you look at the chart below, the current stock market downturn is worse than the drop experienced after the September 11, 2001 attacks.
As you can see, the stock market rallied back one month after the September 11 attacks. The rally into the end of 2001 was followed by panic selling in early 2002, but the market then continued higher. Obviously, the market will eventually rebound from where it is today, but it will not happen until investors renew their appetite for risk. If the December S&P 500 contract closes below 850, I think we could see the March 2002 low near 775.
If you’re a day-trader, you have to follow the technicals. You can’t just rely on fundamentals. The swings are just too big. If you’re interested in learning more about daily pivot points, which can be helpful for short-term trading, feel free to give me a call at 866-231-7811.
Conventional Wisdom vs. Reality
It used to be conventional wisdom: when stock markets go down, commodities go up. However in the last few years until now, the bull market in the stock market was followed closely by a bull market in commodities. The stock market peaked almost one year ago in October of 2007. The commodities market peaked in the month of June 2008. When the stock market began falling this year, commodities initially continued higher, but commodities soon followed. They since continued to fall with the stock market because to many investors they represent an asset that contains risk.
Where did the investors run to for safety? Initially, it was gold, the U.S. dollar and U.S. Treasuries. The price of gold shot up to $980 an ounce in July 2008 on safety concerns, but gold has since fallen sharply to near $720 on October 24. In addition to fleeing commodities, investors have also run away from gold because it is still an asset that still carries risk. Investors no longer crave any kind of risk; they just want their money to be safe.
Risk vs. No Risk
Investors and traders that are fearful of the markets no longer want anything to do with risk. This includes the stock market, commodities and even gold. Investors have instead flocked to debt instruments, but not just any debt instruments. They definitely aren’t investing in corporate bonds. Instead investors have sought safety in U.S. Treasury markets. They want passive income, but not long-term debt.
Fearful investors have been more interested in short-term debt than long-term debt because of uncertainty. Investors and traders are mainly concerned with preserving capital.
If the stock market stabilizes and fear subsides, I think commodities will stabilize too. At that point, you may want to look for some value in commodities, such as corn, sugar, or gold.
In the short-term, the focus will be on whether or not the big players want risk or no risk. Eventually, the appetite for risk will slowly come back, but I think volatility is here to stay, at least until the end of the year. The market will have some big up days and some big down days. However, keep you eye on the tone of the market, specifically, are investors seeking risk or no risk?
Not too long ago, everyone was craving risk. Investors and traders big and small were seeking returns and even leverage to boost those returns. Things have definitely changed. Many just want their money back now. Some have even become fearful of putting their money in banks. Mattresses are probably being stuffed more now than they were last year.
However, what matters more are what the big players, or institutional investors, decide to do. They can’t just dig a whole in the backyard and fill it with their money. They’re controlling billions of dollars and it’s not going to work that way. They’ll seek safety in the U.S. dollar and Treasuries until their appetite for risk returns.
Jeff Friedman is a Senior Market Strategist with Lind Plus. He can be reached at 866-231-7811 or via email at jfriedman@lind-waldock.com.
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