The last time the “fear index” was this low, a crash was just months away
In October 2008, in the throes of the Great Financial Crises, legendary investor Warren Buffett famously wrote: “Be greedy when everyone is fearful, and> READ MORE
In October 2008, in the throes of the Great Financial Crises, legendary investor Warren Buffett famously wrote: “Be greedy when everyone is fearful, and> READ MORE
Since taking office, U.S. President Donald Trump has cast a shadow on many longstanding trade relationships. He's pulled the U.S. out of what was going to be a> READ MORE
“May you live in interesting times” is an old Chinese proverb. While it may sound like a blessing, the saying is actually a subtle curse, something you might> READ MORE
Since Donald Trump won the U.S. election on November 8, global financial, telecom and energy stocks have surged higher. But the party may be coming to an end for> READ MORE
In October 2008, in the throes of the Great Financial Crises, legendary investor Warren Buffett famously wrote: “Be greedy when everyone is fearful, and fearful when everyone is greedy.” Over the course of his career, he has made a fortune from this contrarian philosophy of going against the herd.
If he’s right, it might be time to be fearful. Why? Because the stock market “fear index” is at its lowest level since 2007 – right before the global economic crisis.
How to measure fear
The “fear index” is another name for the VIX index, which is a measure of anticipated market volatility.
It’s based on option prices of individual stocks in the U.S. S&P 500 index. When investors expect more price fluctuation (that is, for prices to bounce around more), the VIX goes up. And volatility is greatest when markets fall.
As the old saying goes: The market takes the stairs up, and the elevator down.
Quoted as a percentage, the VIX is currently around 11. That generally means the market expects an 11 percent range of movement in the S&P 500 index over the next 30 days. For comparison, the VIX hit an all-time high of 89.53 on October 24, 2008, in the depths of the global economic crisis.
The VIX rises when investors are surprised and scared. Investors panic-buy options to protect against further losses. As a result, implied volatility increases.
(One estimate suggests that if the VIX had existed in 1987 – it was instituted in 1993 – it would have hit 120 during the October 1987 stock market crash in the U.S.)
So the VIX index is a measure of how anxious large investors in the S&P 500 are to insure their portfolios. Put options – which increase in value when the underlying security goes down – are widely used by institutions as insurance against losses in the stocks they own. When investors fear a market decline, put options are increasingly in demand, so the price of put “protection” rises.
Generally speaking, the VIX goes up during times of uncertainty and fear, and goes down when investors are complacent or greedy.
The lowest VIX reading ever recorded was 9.39 on December 15, 2006. In recent days, the index has dipped under 11. According to investment bank Goldman Sachs, since its inception, the VIX index has traded below 11 on only 1.8 percent of trading days (grey lines on chart below).
In recent years, there have been some short-lived declines in the S&P 500 and spikes in the VIX. In August 2015, for example, the S&P 500 dropped 11 percent in a little more than a week, causing the VIX to briefly peak above 50. And in the beginning days of 2016 the VIX surged to more than 30.
But the stock market hasn’t seen elevated volatility since 2011. And, based on current VIX readings, investors don’t expect much volatility.
Right now, investors fear little
One thing is for certain – global stocks have been on a roll. The S&P 500 is up 9.8 percent since the election, and global indices aren’t far behind. The so-called “Trump Rally,” which we expect to end, is based on expectations of higher corporate profits from the new U.S. president’s pro-growth policies. Trump has proposed slashing corporate income taxes from 35 percent to 15 percent, and eliminating many regulations in financial, energy and other industries. (We previously wrote about the industries that will do well under a Trump administration… here.)
Does a low VIX reading point toward an imminent market top? Not necessarily. The rock-bottom VIX only indicates that optimism and complacency are high among the largest investors in the S&P 500 index. This attitude could continue for a while, but it’s a warning (re-read the Buffett quotation at the beginning of this piece).
Why you should be prepared to go against the herd
While rising prices may have already priced-in Trump policy benefits, the implementation of these policies is by no means a certainty. Also, the U.S. Federal Reserve has indicated that it expects to continue to raise interest rates – which will counter President Trump’s expected economic stimulus plans. The more that risk assets (like stocks) rally, the more aggressive the Fed is likely to be in raising rates. After nearly seven years of near-zero rates, tighter monetary policy will be a big challenge to global markets.
This is a difficult mix. The timing is difficult, but the low VIX suggests that the U.S. and global markets might be primed for a correction.
That doesn’t mean it’s time to panic… it just means that you should be careful and selective. Just because the market is complacent, it doesn’t mean you should be.
Keep watching your stop-loss levels carefully, and keep an eye on the VIX index.
How else should you protect your portfolio? I’ll write about that next week.
Since taking office, U.S. President Donald Trump has cast a shadow on many longstanding trade relationships. He’s pulled the U.S. out of what was going to be a transformative trade deal with Asia. He’s attacked Japan’s and Korea’s trade policies. Threatening a trade war with China was a staple of his campaign for the presidency. He’s talked about imposing a tariff on goods imported from Mexico.
With a new victim almost every week since his inauguration, what country could be next in Asia on his hit list?
Countries posting a trade surplus with the U.S.
One way to predict Washington’s next move is to look at countries that run a large trade deficit with the U.S. A trade deficit is the amount by which the cost of a country’s imports exceeds the value of its exports. If the U.S. runs a trade deficit with country X, it means that a country X sells more to the U.S. than the U.S. exports to country X. There’s nothing inherently wrong with running a trade deficit. But a trade deficit is like a red flag to a bull for a U.S. government focused on bringing manufacturing jobs back to U.S. soil.
As the graph below shows, China is the leading offender. The country posted a US$347 billion trade surplus in 2016. (If a country runs a trade surplus with a trading partner, by definition the partner is running a trade deficit.) After China, in 2016, Japan, Vietnam and South Korea are the next three Asian countries that have the biggest trade surpluses with U.S.
In contrast, the U.S. actually runs a trade surplus with Hong Kong and Singapore. (Still, in November, Trump singled out Singapore as a country that’s taking jobs away from Americans.)
Another issue raised by Trump administration is whether a country is “artificially” trying to achieve an “unfair” trade advantage with the U.S. by causing its currency to fall in value. A weaker currency relative to the U.S. dollar makes that country’s imports cheaper in U.S. dollar terms. And a weak currency is an important factor in the trade balance.
By this measure, Japan, Indonesia, India and Malaysia are the biggest culprits over a five-year time horizon, as shown below. These countries have seen the greatest weakening (that is, depreciation) in their currencies relative to the U.S. dollar. Over the past year, the Philippines, China and Malaysia have seen the most depreciation.
One of the U.S. government’s contentions has been that China has been trying to manipulate its currency to gain an unfair trade advantage over the U.S. But in fact, China has been trying to prevent the depreciation of its currency – not promote its depreciation.
According to a U.S. Department of the Treasury report, “China’s intervention in foreign exchange markets has sought to prevent a rapid RMB [or renminbi, China’s currency] depreciation that would have negative consequences for the Chinese and global economies.” The department estimated that from August 2015 through August 2016, China sold more than US$570 billion in foreign currency in an effort to prevent rapid depreciation of its currency.
The U.S. government is constrained in what it can do to retaliate against offending trade partners by World Trade Organisation (WTO) rules. And as the U.S. steps away from its prior role as the custodian of global trade, China is ready to fill the gap with a raft of other trade deals.
To learn more about how to protect your portfolio as Donald Trump searches for his next trade battle target, read our free special report… here.
“May you live in interesting times” is an old Chinese proverb. While it may sound like a blessing, the saying is actually a subtle curse, something you might wish upon an adversary. The implication is that “interesting times” are chaotic and painful.
2017 is shaping up to be very interesting. Since the victory of Donald Trump in the U.S. presidential elections in November, global stock markets have surged higher, with the S&P 500 up about 8 percent since the U.S. election and 2.6 percent year-to-date. Meanwhile, the MSCI Asia ex-Japan index, after dropping in the wake of Trump’s victory, has reversed course and is up 6.7 percent in 2017 so far.
However, as I’ve written before, I think that the so-called Trump rally is due to reverse soon, as mean reversion comes into play. And with high levels of uncertainty in markets, now is also a good time to buy one of the assets that performs best during times of uncertainty – gold.
As the graph below shows, gold prices are up nearly 6 percent so far in 2017. Precious metals had a bout of weakness after Trump’s surprise victory. Global investors bought U.S financial and manufacturing stocks and sold “defensive” assets like gold.
From the election to mid-December, gold dropped about 13 percent. However, since then, it’s rallied to about US$1220, a gain of 9 percent. Gold remains nearly 8 percent below its highs from June of last year – a level it’s likely to revisit before long. It’s not going to happen immediately, but I don’t think it’s a stretch for gold’s 2011 highs – of US$1,837/oz, or about 50 percent above current levels – to be in sight.
Three reasons why 2017 could be a big year for gold
The U.S. dollar is likely to weaken
Trump recently said the U.S. dollar is “too strong.” He has accused China of manipulating the yuan lower relative to the dollar to benefit China’s exports. The dollar is up 2 percent since the election, but for Trump to bring manufacturing jobs back to America, he will need it to weaken. As gold and the dollar usually trade in opposite directions, a softening dollar will be positive for gold.
The “Trump Rally” will eventually succumb to mean reversion
As I mentioned, global stocks have been strong since the election. Investors have been anticipating Trump’s anti-regulation, pro-growth plans will stimulate global corporate profits. But these policies face political obstacles and will take time – if they are ever enacted. It’s only a matter of time until the current “risk-on” environment turns to “risk-off.” Gold—the fear asset – will benefit.
Odds of a “Black Swan” event that will ignite gold prices are increasing
Black swan events are unexpected events that have outsized and serious ramifications – such as the global economic crisis of 2008, for example. The unpredictability of some of President Trump’s early actions in office, and the poorly thought-out implementation of some of the new government’s policies, suggest that a black swan (which by definition is almost impossible to predict) may emerge from the depths. (Last week we talked about another possible black swan, here.)
I believe it’s crucial as an analyst and investor to be objective. Letting your political views cloud investment decisions is a good way to go broke. It makes a lot more sense to position your portfolio to profit from what may happen (see here for one idea that’s working out) – and protect it at the same time.
Fresh demand from Islamic Investors is hitting the gold market
As we discussed here and here, Islamic investors in modern times have shied away from gold-related financial products. This is because the legality of gold investments has long been unclear under Islamic Finance law.
However, as anticipated, a Sharia Gold Standard was approved on December 5. The Accounting and Auditing Organization for Islamic Financial Institutions and the World Gold Council teamed up to clarify the rules for Islamic gold investing under Sharia Law.
The Standard allows gold-based Sharia-compliant products, like ETFs, to be offered throughout the Muslim world. Indications are that the SPDR Gold Trust – the largest gold ETF in the world – qualifies under the guidelines.
The Sharia Gold Standard will stimulate gold demand across Muslim markets like Malaysia, the UAE and Saudi Arabia, where Islamic Finance is well established. Indonesia and Pakistan are pushing for Islamic Finance to play a greater role in their economic infrastructure.
Islamic savers and investors currently hold almost US$2 trillion in assets, an amount that is expected to grow to US$6.5 trillion by 2020, according to the Islamic Finance Stability Board.
President Trump’s ban of immigrants from seven predominantly Muslim countries, and the ensuing backlash, underscores the uncertainty many Muslims face around the globe. The world’s 1.6 billion Muslims may increasingly be able to invest in gold as a hedge.
Just a 1 percent allocation to gold among Islamic investors would equate to nearly US$65 billion, or 1,700 tonnes, in new demand. That’s almost double China’s estimated total 2015 demand for gold.
So as the Trump rally loses steam, and investors get a reality check from political and geopolitical risks, expect risk-on to become risk-off. Meanwhile, the chances of a black swan of some sort are rising. Finally, a major new source of gold demand is arriving via Islamic Finance.
One easy way to own gold is through the SPDR Gold Shares Trust ETF (code O87 in Singapore; ticker GLD on the New York Stock Exchange) or the Value Gold ETF on the Hong Kong exchange (code: 3081).
Since Donald Trump won the U.S. election on November 8, global financial, telecom and energy stocks have surged higher. But the party may be coming to an end for those sectors – and just starting for others.
Since the election, the U.S. S&P financials index is up 19 percent, the telecom services index is up 14 percent, and the energy index has jumped 10 percent (compared to the 6.5 percent increase in the S&P 500 Index). Investors are anticipating that these industries will benefit from Trump’s policies. (Before the election, we mentioned that financials and the energy sector, specifically natural gas, would do well if Trump won.)
Not surprisingly, these sectors of the MSCI All Countries Index have also outperformed other global sectors, as shown below.
Meanwhile, before the 2016 election – that is, a bit more than the first eleven months of the year – the S&P 500 Index was up 6.6 percent (the MSCI World was up 5.4 percent). The S&P Financials Index had gained 5 percent in the 11 months before the election, and telecom services were up 9 percent over the same period. Energy was having a good year anyway – the U.S. energy sector was up 17 percent before the election.
However, there is an old investment saying: Buy the rumour and sell the fact. As inauguration day (January 20) approaches, it’s time to sell the Trump Rally.
Conversely, sectors that have suffered since Trump’s election are due for a reversal. Bonds, healthcare and alternative energy may soon trade higher, as the Trump Rally bumps up against political reality.
What happens when a rally meets reality
While giddy investors could be right that President Trump’s policies will benefit some industries, there is just one problem: The pro-Trump stocks are already way up, so a lot of these changes are already priced into stocks – and the President-elect hasn’t even taken office yet.
And once he’s inaugurated on January 20, expect real-world Trump policy to begin deviating from investor expectations.
The president-elect’s cabinet has a large number of billionaires and Wall Street veterans who will push pro-business, anti-regulation policy. Oil and gas industry veterans joining the Trump team will want to drill more, while cutting back environmental rules. The theory is that tax cuts, business friendly policies and infrastructure spending will boost industrial companies and U.S. growth.
These policies may be implemented – and may have the anticipated impact. But history and the bureaucratic realities of politics suggest a lot won’t. And even if Trump turns some of his campaign promises into policy – a wall on the Mexican border, a 45 percent tariff on China imports and reversing climate agreements – it will only be after a long fight. The U.S. Congress, angry Democrats, state governments, competing countries and market forces can be expected to throw roadblocks in front of Trump policy. (Of course, other factors – like rising interest rates – will also affect market movements.)
Trump’s victory is affecting Asian markets, too. The MSCI Asia ex Japan Index, which tracks the performance of most major Asian markets except for Japan, has lost 4 percent since the election. China’s Shanghai Composite is flat since the election and Hong Kong’s Hang Seng is down 3 percent.
Trump’s comments on Asia, and China in particular, may be partly responsible for this weakness. (For more details on how Trump’s presidency could affect Asia, download our free report on the subject here.)
It may be time for mean reversion
In the meantime, we think it’s time for mean reversion to come into play during the early days of Trump’s presidency. As we’ve discussed previously, market prices have a strong tendency to reverse extreme price movements and move back to average – also known as mean reversion. After a period of rising prices, securities tend to deliver average or poor returns. Likewise, market prices that decline too far, too fast, tend to rebound.
Humans aren’t naturally good at anticipating mean reversion. When our favourite sports team wins the championship, we tend to believe odds are high it will duplicate the feat next year. Same players, same coach, great team – why wouldn’t they repeat? But back-to-back championships are very rare.
When deciding which stocks to buy, investors tend to focus on recent performance. If a stock’s price has been rising, we tend to believe that means it’s a good investment. Typically it doesn’t work out that way.
In fact, behavioural scientists have a name for our tendency to optimistically buy into markets just before they top and turn down, or panic and sell shares at the bottom. It’s called The Dumb Money Effect. Humans are hardwired to follow the crowd. While that behaviour may have kept cavemen alive in ancient times, it’s bad for modern investors’ portfolio returns.
Rather than jumping on the Trump Rally bandwagon, investors should consider markets and sectors left behind by the Trump Rally.
Sectors to consider
From a mean reversion perspective, several sectors appear especially interesting as we begin 2017:
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