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I hope every one had a fun and relaxing Memorial Day weekend. Pools are open, school is winding down, and summer is almost here.
There were some fireworks over the weekend, but the not the fun kind. North Korea’s Kim Jong Il staged a nuclear bomb test and fired a couple short-range missiles. It’s reported that stocks in Asia were lower after the tests, but I think we need to be more clear about the risk that North Korea poses to the financial markets.
Kim Jong Il has a long history of provocative actions that are usually designed to give him leverage. In essence, he’ll stop the tests if the world gives him money. Sure, it’s blackmail. But it’s been the easiest way to deal with the pest, especially if you’re South Korea or Japan as his primary targets, or the U.S. as the first line of defense for those nations.
I expect we are moving toward a situation where blackmail money isn’t enough. There will probably be a UN Security Council resolution and more pressure on North Korea to cease and desist.
But is North Korea’s nuclear testing really a market moving event? I’d have to say no, it is not.
*****Investors have already ramped stock prices in the face of significant economic problems. Of course, there are some pretty strong signs that the economic free-fall has stopped and the financial sector has stabilized. In this environment, corporate earnings can be expected to stabilize and that means it’s once again possible to make somewhat reliable valuation estimates for individual stocks.
In other words, a measure of uncertainty has been removed from corporate earnings. That’s what’s fueled the rally since March 10th. There’s less risk of massive earnings revisions, and that’s showed up in the VIX.
*****The VIX is the Volatility Index kept by the Chicago Board Option Exchange (CBOE). The VIX measures how much it costs to hedge a portfolio with put options against a 10% drop in the S&P 500.
The specifics of hedging with put options aren’t important here. The point is that the VIX has dropped to its lowest levels since September 12, when Lehman Bros. declared bankruptcy.
The VIX is low because institutional investors are not using put options to hedge their stock holdings. This can mean two things: investors believe stock prices are heading higher; or, as Bloomberg suggests, many investors don’t have enough profits to justify the expense of hedging. Each has very different implications.
*****If institutional investors believe there’s more upside, great. We can expect the rally to continue, or at worst, stabilize. But if investors don’t have enough profits to justify the hedging expense, it suggests they’ll simply sell at the first sign of trouble to lock in what gains they have. That’s not as good because that could send stock prices sharply lower.
*****Contrarian investment wisdom says that "When the VIX is low, it’s time to go." This means that when investors ignore market risk, and send the VIX to low levels, a situation of "irrational exuberance" is created and it’s time to keep an eye on the exits.
But the VIX has a ways to go before it starts to indicate that investors are overly optimistic. For now, I think we’re better off interpreting the relatively low levels on the VIX as an indication that much of the systemic risk to stocks has been removed.
Now, we have to get through the summer months, which is traditionally the worst period of the year for stocks…
How do you interpret the VIX and the numbers we’re seeing? Are you planning to load up on shares or take profits at the first sign of market weakness?