Volatility — the rate at which prices move up or down — has leaped in many security markets recently. The Federal Reserve Bank of St. Louis's Financial Stress Index, whose 18 components include yields on junk and corporate bonds, an index of bond market volatility, and the Standard & Poor's 500 index, is almost at a four-year high.
I believe the restrictions on bank trading imposed by the 2010 Dodd-Frank Act, including the ban on banks' proprietary trading and increased capital requirements, are a key reason, at least in the U.S. Large banks and other financial institutions simply aren't carrying the big trading positions they once did, and therefore, liquidity in many markets has atrophied.
Then there's China's stock-market nosedive and currency devaluation. They provided a wake-up call about China's slowing growth and the global effects on commodity prices, emerging markets and money flows.
Volatility in U.S. markets may also be due in part to the delayed effects of the ending of quantitative easing by the U.S. Federal Reserve late last year. Since stocks began to revive in March 2009, equities have been floating on a sea of Fed money with little connection to the slowly growing economy beneath — something I dubbed "the Grand Disconnect."
Then there's the shaky base of corporate earnings growth. With slower economic growth, sales gains have been slight. And business pricing power has been almost nonexistent, with minimal inflation and a strong dollar. So top-line revenue growth — the foundation for profit gains — has been largely missing.
Resourceful American businesses have cut costs ruthlessly to make up for the lack of revenue growth. As a result, profits' share of national income leaped from the lows of the 2007-2009 recession. But profits' share has stalled over the last several years, reflecting the slowing of productivity growth.
Also, stocks aren't cheap relative to earnings. The price-to-earnings ratio on the S&P 500 index over the last year is 18.2, compared with the norm of 19.4 over the last 20 years. But the better measure is the cyclically adjusted ratio, developed by Robert Shiller, the Yale University economics professor, which uses real earnings over the preceding 10 years to iron out cyclical fluctuations.
On that basis, the current price-to-earnings ratio of 25.84 is 55 percent above the long-run norm of 16.6. And since the norm has been about 16.6 almost since 1992, price-to-earnings should run below trend for years to come, assuming the 16.6 remains valid.
The past month's leap in volatility, especially for stocks, reminds me of the prelude to the Oct. 19, 1987, stock-market crash, when the Dow Jones Industrial Average plummeted 22.6 percent in one day and the S&P 500 fell 20.5 percent. The S&P 500 volatility in the 10 trading days before the crash was 1.8 percent, compared with the previous month's average of 0.8 percent.
More recently, S&P 500 volatility in the 10 trading days prior to Sept. 4 was 1.9 percent, while the one-month daily percentage change from mid-July to mid-August was 0.5 percent.
So I have to ask: Is the current volatility forecasting big selloffs into inadequate liquidity, as happened in the weeks leading up to the 1987 crash? Beyond the volatile markets, there are other warning signs. Interestingly, computerized trading may also be helping to feed volatility, much as it did in 1987.
Junk bonds, which become notoriously illiquid in times of stress, enjoyed huge popularity from 2008 until recently, as investors lusted for yield in an era of low interest rates on Treasurys.
But recently, yields have jumped, as have spreads between Treasurys and junk bonds. Junk bond prices, led by energy issues, fell 5.7 percent from April through August, and investors are on track to withdraw money from junk bond mutual funds for the third year. Similarly, yields on investment-grade bonds have been rising, as have their spreads against Treasurys.
Keep an eye on Treasurys. The night before the 1987 crash, 30-year bond prices leaped 12 points in the stampede to safety. Credit markets often give warnings ahead of major global economic problems and equity bear markets. That was certainly true in 2000 and 2008.
The economic outlook is uncertain, but the recent leap in volatility in equities and other markets may be warning us of more big selloffs ahead.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the author of this story: A Gary Shilling at [email protected]
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