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Can The US Economy Handle A Meaningful Downturn In Financial Asset Prices?
From ConvergEx' Nicholas Colas
Financial asset price volatility gets a bum rap. Everything in moderation, yes… But the unusually quiescent capital market behavior of the last few years isn’t really doing anyone any favors over the long run. Today’s note reviews the benefits of a more volatile bond and stock market: everything from the possibility for truly skilled fund managers to make outsized returns to a very necessary reset of investor and corporate behavior. As bond and stock markets get twitchier - and that process is already underway – just remember that there are many silver linings in the storm clouds that are gathering.
For much of the history of modern medicine, the function of the human appendix has been a bit of a mystery and common wisdom held that it was essentially useless. About the only thing doctors knew was that it could become infected and that its removal caused no adverse health consequences. Medical professionals have been performing appendectomies since the 1730s, and one brave Soviet doctor managed to remove his own infected appendix in the 1960s while stranded on a scientific outpost in Antarctica. Don’t try that one at home, kids.
More recently, the appendix has gotten a reprieve and some researchers believe it may have several useful functions after all. As it turns out, that little sac in your abdomen acts as a back-up supply for the bacteria your body needs to stay healthy. It also serves a function in prenatal development, helping to balance hormone levels. Clever surgeons now use the appendix to reconstruct internal organs damaged by cancer or infection. In short, the appendix does have its uses – plenty of them, actually.
For capital markets, asset price volatility is much like the human appendix. The rally in both stock and bond markets – especially in the U.S. – has come with little in the way of wayward price action. It has been a “Set it and forget it” move for stocks for three years, with little in the way of classic 10% pullbacks to shake out weaker hands. The rally in bonds, thought unlikely at the beginning of the year, has been similarly uneventful. It is as if investors have extracted the seemingly unnecessary appendix of volatility and, with the market seemingly unaffected, decided it has no real function.
The problem is that volatility is actually important to the proper functioning of capital markets. In fact, it is critical to both effective societal asset allocation and as a way to judge the skill of managers on Wall Street and Main Street alike. It isn’t just price levels that define capitalism; it is the correlated spectrums of risk and return from sure bets to highly speculative ventures that keeps the machine running smoothly. The journey really is just as important as the destination.
That may come as an unwelcome message to those accustomed to steadily positive returns over the last 5 years. For many investors, the 90% advance in the S&P 500 or the 86% return in the Russell 2000 have been a welcome salve after the burns of 2007-2008. All that has come with very low levels of both actual and expected price volatility, as expressed by measures like the CBOE VIX Index. Since rising volatility tends to drive asset prices lower, what will the harvest be when stocks finally do start to act more like their crankier old selves?
Spoiler alert (sort of): stock price volatility is rising, and October is historically a seasonal high water mark for zippy price movements. Hundred-plus point moves in the Dow now come regularly, and the CBOE VIX Index is up from 12 to 15 in the last month. In short, stock volatility is back and it wants to know why we changed the locks and threw all its clothes on the front lawn.
And yet… There are several silver linings shot through those incoming storm clouds. Consider the following points:
- Imagine you are a public company Chief Financial Officer and you must explain your cost of capital to the rest of the organization and your Board of Directors. This is a tough concept for non-financial professionals, and they tend to look at the stock price as a way to shortcut the tedious math behind the calculation. High stock price equals “Things are going great! Expand the business. Buy other companies. Grow, baby, grow.”
Price volatility is what keeps those animal spirits in check and forces corporate Main Street to watch their pennies. Now, the last five years haven’t exactly been a rapper’s birthday party of corporate spending, so incremental stock price volatility isn’t just about keeping the lid on profligacy. Rather, it will be a warning shot to keep corporate America focused on the very best expansion projects and overall asset mix. And that’s always a good thing for investors and society as a whole.
- Then there’s the Wall Street side of the volatility equation. The last five years have been a boon to passive investing – why buy the active manager cow when you can get the milk of high returns for (almost) free? The recent news that the California Public Employees Retirement System plans to scale back their exposure to hedge funds is just one touchstone in that trend. So is the persistent move of capital from actively managed mutual funds to overwhelmingly passive exchange traded products.
It’s all funds (sic) and games until someone loses an eye, as every parent warns. Price volatility will allow active managers to feel some sunlight after the long eclipse of the last half decade. Truly skillful managers – long only or hedge fund, it matters not – welcome volatility since it allows them to find the babies mixed in with the bathwater.
- Economic volatility, to the degree it comes with asset price moves, also plays a productive if short-term painful role in capitalism. Consider that the times when the CBOE VIX Index ran consistently below its long run average of 20 (14.9 as of Friday) are all periods of bad capital allocation. The mid-1990s sewed the seeds of the dot com bubble. A decade later, the same VIX levels travelled hand in hand with the housing bubble and the setup for the Financial Crisis. Low volatility and poor societal capital investment share a room in the orphanage of failure.
The key question now is “Can the U.S./global economy handle a meaningful downturn in financial asset prices?” The short answer is that it may not have a choice. The Federal Reserve has done what it can to juice the American economy and has the balance sheet to prove it. Central banks, for all their power, do not control long term capital allocation or corporate hiring practices. Fed Funds have been below 2% for six years. If the U.S. economy can’t continue to grow in 2015 as the Federal Reserve inches rates higher, there are clearly larger issues at play. And those private sector problems will need private sector solutions.
In short, higher asset price volatility from current levels isn’t something to fear if you consider its function over the long run. A little pain now will save a lot of trouble later.
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No
Yes. But only if "handle" means "go into another deep recession".
GoPro baby!!!
No. Because those "assets" are what is being used to leverage the house of cards. Any meaningful downturn will have a cascading effect, thus they'll only allow it when they want it to happen.
Yup.
Volatility, also known as "I picked the wrong stock and need an entry point so that my financial model allows me to catch the wave and cover my losses" (sic)
In god and Janet´s plunge protection team we trust.
Are you suggesting that there is a market for true price discovery? Sorry, I disagree.
Headline should read: "How Will The US Economy Handle A Meaninful Downturn in Financial Asset Price?"
still assumes that there is a legitamate market when there isn't.
Right, LoP. The "market" is just another policy tool to further implement an agenda which would otherwise be repugnant for those who will suffer the consequences.
Perspective is always important. I see plenty of global opportunities. remind us, 90% of the human population lives on how many dollars per day again? I don't see anyone getting nuked anytime soon, do you?
Nuked? Who's to say what the outcome will be. I certainly don't know. Regardless, I see a lot of suffering. Does one relish finding a pearl in the sea of hardship and suffering?
The CRIMINALS running the Federal Reserve will keep lying that they will raise rates and they will keep pushing that date off into the future.
If they could raise rates, they would have already done so.
They know, that the minute they raise rates by even a cunt hair, it's game over for their bullshit recovery story.
I agree with your "cunt hair" assestment of the Fed raising rates....vmromk....
Next up: 50 year fixed mortgages for the masses... home prices to surge to new record levels!!!!!
It's coming b/c that's all that can be done anymore.
Raising rates even a small amount will cause the market to start gyrating and that scares the shit out of them since they KNOW which direction it will likely go.
There will be no meaningful downturn in USD terms because the Fed will go full retard at the slightest sign of a meaningful correction. The USD is another story.
does a chicken have lips? the sole purpose of this travesty was to shore up things that bolstered balance sheets. if assets go down, balance sheets go to hell fast
With all those stock buy back's with borrowed money any wobble at all will start a panic since those balance sheets are predicated on non-GAAP hope and change.
No
What you meant to say was "Can the US Financial Sector Handle a Meaningful Downturn in the US Economy?"
We are finding out very soon.
Please, the vast majority of Americans have few real "financial assets" and no idea what real wealth is. There is no "market" you stupid fuck. Look at volume 90% of the time. Kevin Henry's got this...
until he doesn't...
No.....but people who love a good dumpster fire like me will at least FEEL better about it.
What sucks about a market crash is that the super rich ppl don't lose money (they find crashes as a "buying opportunity", even as society burns); its our fathers and grandfathers who do.
But yet again, the boomers need to feel pain, I believe, until shit turns around. They have their toys, their mortgages, their jobs.......they need to lose all of this for them to realize that their sons and daughters are fucked.
The pain should have come in 2008 and to the Banks/Corporations/Insurers who were gambling with other people's money.
Instead, the pain was passed on to the middle class and future generations.
Where does that kind of thing get you? Hell, eventually.
The aggregate numbers, no. But people always will have a need to buy and sell things. The market that most people are familiar with will continue.
The fancy one where you are leveraged 100x and do lines of top notch blow off of a Ukrainian hooker's navel, well that one might be in trouble.
Most people will actually do better if we blow this financial economy up. While we are at it, let's start using something else for exchange other than a private bank's currency lent out of thin air with interest attached.
pods
Always amazed me about how we classify "the market". Everyone seems to equate the SP500 as the primary market. Except, the vast majority of parasitic non-functioning entities are in the SP500. Seems to me that a collapse in SP500 would be a good thing. As you say, capital would be forced to do something else other than 3 card monty (aka the Stock Market).
Globalization would be toast granted, but that's a good thing in my book.
Whenever I think about today's economy, I am reminded of the story of the Mexican Fisherman and the Harvard MBA guy:
http://bemorewithless.com/the-story-of-the-mexican-fisherman/
The thing that keeps me up at night is trying to imagine a world where we are all not running on a hamster wheel trying to keep pace with the accruing interest coming for us.
Never mind all the productivity gains that have been stolen over all of our lifetimes.
But we still trudge on, burning our lives away for a Goddamm bank so some psychopath can do some blow off of some girl running on the hamster wheel.
pods
RE
But hey, invest in the stock market - its totally not rigged!
Good Company News Is More Likely Announced Around The Time CEOs Sell Shares, Report Findshttp://www.ibtimes.com/good-company-news-more-likely-announced-around-ti...
I, for one, would like to see Steve Liesman's head explode from stawks not coming "off the lows".
Vacuums do not explode...you will see an implosion most definitely.
"If the U.S. economy can’t continue to grow in 2015 as the Federal Reserve inches rates higher, there are clearly larger issues at play."
Here we go again with the 'Fait accompli' of the Fed Raising rates, when it is still (6) months away - and that is, a.) You think it's going to actually happen, and b.) Nothing significant will change by then - and certainly nothing economically negative. Gawd...
Just ask a broke debtor if he wants higher rates :)
Where is there a Vix for measuring say "Detroit...Triple AAA!"
Oh, right. Diplomatic Immunity!
It's hard to call the USA an amalgamation of 50 States but more like "one state" (New York) "repeating itself" (all run by a Bank.)
Very interesting to read the history of Yalta and the creation of the United Nations. Does the Soviet Union get three votes? If so does the USA too?
There won't be a meaningful downturn unless the market can attract enough suckers to invest in long equities. Over time there will be enough suckers via 401k/pension contributions.
This. The next downturn will be driven by the boomers retiring and needing the money from their pensions. Convential wisdom would say that when the old farts retire, youngsters will finally start working and paying into pensions and 401ks which will provide balance. What happens if the youngsters are replaced by technology instead. Who will be on the BUY side when the boomers cash out?
Seriously?!
Boomers are going to have to sell off assets to build an addition for their youngsters so they can live off their pension too.
Yep all those twenty somethings living in the basement, neck deep in college debt, working low wage jobs and buying iWhatevers are gonna save our ass... you betcha.
RE:
AND:
A) we can't afford the 401ks and pensions because the market goes to the moon which will be wierd because
B) most of the younger workers don't get offered 401ks/pensions to begin with and
C) most of us are more interested in fantasy football than the stock market because at least when you win in fantasy football, the CASH actually hits your HAND.
Also, what if the youngers generations need more cash in their hand because we live in a ZIRP enviroment where everything needed (healthcare/car/housing/college) is paid with DEBT, and the the cash we'd usually save with gets shuttled off to a rentier.
NVM those of us who won't invest in the market because IT'S IMMORAL.
"Now, the last five years haven’t exactly been a rapper’s birthday party of corporate spending..."
LBOs, M&A activity, and stock buybacks have been pretty darn profligate lately. Did I miss something here?...And if not, what is this dude smoking?
I suppose it depends on what the definition of “can” is
The can has been kicked?
“Can the U.S./global economy handle a meaningful downturn in financial asset prices?”
you really need to ask this question adjunctly with duration of downturn.
Last go round ... march 2009 low Dow 6500 ... by june 2009 Dow back to 9000 (and still going)
V shape market action, imo, US handles OK
l___________________l
not so OK
I know my economy can't .
why, is your economy dependent on income from leveraged bullshit?
The job of the PPT was not just to plump stock prices, it was also to make sure there were no suicide inducing 400 point drops. And if there were, then the helpful people at ARCA would bust any trade that made the protected people sad. Cant have Valerie Jerkitt or the NiggityNogs at Ariel Capital feeling like the worthless burrheads that they really are, same goes for the dumb white liberals who are perpetual loosers at anything they touch.
Why doesn't anybody get it? If the stock market goes down 20 % does that mean that 20% of that money disappear? NO ITS TRANSFERRED TO SOMEONE ELSE. Its not like they're taking $$$ and burning them.
It actually does dissappear because it is unrealized and never liquidated, much like any other Ponzi scheme,
I should clarify my statement. I understand about leverage and unrealized gains. Old saying you haven't made or lost money until you're out. I guess what I really mean is if banks can print money at their discretion, it doesn't matter what the price of the "market" is. Better for the banks to let stocks crash and own even more of everything. They always can print more $$. Accumulation Distribution. With every crash less people owning more everything. Until there is one major bank per country, continent, world.
When dow drops 10% look out for rolling heads. Fokkers will panic and go isis when this levered up shit feels any strain.
Does the Pope shit in the woods ??
This is clearly a misleading, gotcha question. it presupposes that the economy hinges on the Dow/S&P/Nasdaq.
However, the vast majority of americans don't even own stock, except perhaps in a 401k, so what fucking difference does a bear market make? So what, warren buffet and co. lose a few billion. joe mainstreet is still trying to feed his family, heat his home, clothes his kids, and make his monthly slave payments. FU, wall st. FU, big government. All you have done is destroyed 100 million homes. I'm sure you'll really notice the "downturn" while eating caviar on your yacht with some hired bimbo and blow.
Debt is sold as Asset. When more than half of the population depending on EBT to survive, does it matter any more?
This is worse than the Dark Age.
If you want to know where prices are going, just ask the buyers and sellers of stocks ... I mean on the other side of the trade.
Every trade has a guaranteed buyer backed by a bank with infinite liquidity ... if not a bank itself. These are the specialists and market makers. They set price and they program buys and sells so that they never lose (on the average).
It is a completely rigged game. There are no market forces allowed. Nothing is a surprise. The run-up was planned and if they crash it, that will be planned as well.
I will give you my mathematical derived answer to this question.
Stock market crash 3,1222 % from top on Mondays is max. But not on Hindoe celebration days.
To you guys that keep saying they won't or can't raise rates, I would have agreed with you on this a few months ago but now I think they will raise rates. If and when the risk finally comes home to the bond market, they will have to raise rates to get buyers to play.
You have got to remember the gov and the banks don't care about rising interest rates. They all get free, unlimited money to pay whatever they want. Saying they can't is utter delusional bs. They can.......and I believe they will.
What you guys can't get past is the fall out if/when they raise those rates. Again, the fallout won't affect the people pulling the strings like it will you, me, and everyone else without a printing press. Why do I say this? Because a few months ago, I was in the crowd that said they would never "taper" because the economy cannot survive without QE life support. I know, I know there are other forms of it that act indirectly and behind the scenes, but for them to openly print and extra $85 bil a month to juice the economy was a revelation to the world just how things have been working for the past several decades. Now they are taking that life support off the table, and we all know the economy is not really any better off than it was when they started QE. How will it survive? In my opinion it won't and that is why we are seeing the asset cart starting to shake.....around the world.
They CAN raise rates.......and I believe they will raise rates to drive the final nail in the coffin of what has been the greatest and most free society the world has ever seen. They will destroy the ability to be independent of the gov.....once and for all. They will take away your ability to earn and enjoy the fruits of your labor at a reasonable rate......hell, we are almost there now. But once this country falls FROM WITHIN, there will be no reset. The world will once again be the slaves to those who contol the military might and the resources.......that be the gov. They will confiscate anything from anyone who does not agree with them by the power of the debt they have put out there. "One ring to rule them all." Individuals, businesses, families, etc. have sold their souls of freedom to get what they wanted .....right now.....this minute. In our greed for more....right now......we have given our lives and freedom to a lender. And laugh and scoff all you want but, "THE BORROWER IS SERVANT TO THE LENDER". The whole world is in debt....by design....and that debt has doubled in the last 5-7 years. The repo man is about to come calling. And you smartass, know-it-alls who think they won't pull the plug on this game by raising rates so they can scoop it ALL up for nothing are simpletons still rolling in your naivety.
Just an example of personal responsibilility for all of us is when they rolled out something we wanted at an ungodly price.......and we knew it......yet we went and borrowed what we could to get it BECAUSE WE WANTED IT.......NOW. We are all culpable in this mess. We have reached a point of no return and will have to ride this pony to the end of the line. It is going to be ugly. Some of us won't make it far because we are not going to be willing to hand over what's left of our freedom without a fight. Most will knuckle under and move on with the system. We were given something great and precious and we have squandered it away to pay for the things we coveted at whatever price they demanded.
Optimist.
They WILL normalize, the markets will RESET ( a la 2011), we WILL have a bounce for the year-end bonus then a continuation decline till Spring 2015 when another ramp WILL begin.
See real
http://www.showrealhist.com/RealDow.gif
No...that was easy..if meaningful means more than 3%...
the proof...it has not been allowed to happen...
God damn Hank.
WAIT! WHAT! Krug says we just need MOAR QE!
The world did not stop functioning in March of 2009. McDonalds was still serving coffee. You could even get a burger if you wanted. The traffic lights were still working and the roads were packed with people still going to work. The problem with what happened since is we bailed out the wrong people and restarted the Wall Street gambling casino, getting it ready for the next implosion. Yes, the economy would have survived and in fact been in much better shape at this point if we had not made that horrific decision. The malinvestment and misallocation of resouces that have occurred since will be very painful when they ultimately unwind. No, these actions did not "save" our economy. They just set it up for the next massive nosedive. The markets are topping people. Those who see it are positioning themselves. Look, the financial markets were cut in half, that's 50% for those counting, and the economy contracted what, 5%. We then created job killing, middle class eviserating monetary policies injecting financial gains into the only portion of the economy that didn't need it. Yes, the top few percenters. All in the name of some non-existent, never-existent theory called trickle down. Didn't work, never worked, will never work. But made those in charge (at this point) massively rich. The shell of an economy underneath all this will either ultimately fold under the weight of the rotten subfloor underneath it, or there will a revolt at some point and those in charge will be replaced in the face of what will be their ultimate failure to support the vast majority of those they are supposed to represent. This will be a very hard thing to do given the control mechanisms in place by those presently at the con and the resulting dependent nature of a larger and larger portion of those being governed. I guess only time will tell which way it goes. But, I think it's safe to say the future isn't looking overwhelmingly bright at this point.
The more and more I study derivatives it now appears the main goal of QE may have been to hold up the underlying value of assets that feed into and support the massive derivative market more than help the economy. QE has up to now stopped an implosion of derivatives halting the resulting contagion and shock that would have spread throughout the financial system.
In postponing this collapse the Fed has created a whole slew of new problems. More on this subject in the article below.
http://brucewilds.blogspot.com/2014/03/derivatives-house-of-cards.html
What about gold stocks?