The Random Walk

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The Random WalkFinancial market anal sis

Edited by:

Miles Hamilton

Adrian Booth

Contributions from:

William Whyte

*Pictures from Hargreaves- Lansdown



The Random Walk- Issue 1- Jan 2010 1 Cass Business School

Volatility measures

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0 7 / 1 2 / 2 0 0

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0 9 / 1 2 / 2 0 0

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1 1 / 1

2 / 2 0 0

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1 3 / 1

2 / 2 0 0

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1 5 / 1 2 / 2 0 0

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1 7 / 1 2 / 2 0 0 9

1 9 / 1 2 / 2 0 0 9

2 1 / 1 2 / 2 0 0 9

2 3 / 1 2 / 2 0 0

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2 5 / 1 2 / 2 0 0

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2 7 / 1 2 / 2 0 0

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2 9 / 1 2 / 2 0 0

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3 1 / 1 2 / 2 0 0

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0 2 / 0 1 / 2 0 1

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0 4 / 0 1 / 2 0 1

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0 6 / 0 1 / 2 0 1

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0 8 / 0 1 / 2 0 1

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1 0 / 0 1 / 2 0 1

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1 2 / 0 1 / 2 0 1

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1 4 / 0 1 / 2 0 1 0

1 6 / 0 1 / 2 0 1 0

1 8 / 0 1 / 2 0 1

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2 0 / 0 1 / 2 0 1

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2 2 / 0 1 / 2 0 1

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2 4 / 0 1 / 2 0 1

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2 6 / 0 1 / 2 0 1

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SPXIndex - Volatility 30 Day (R1) VIXIndex - Last Price (R1)

The VIX index, the US barometer of risk aversion- dubbed as the ‘ fear gauge‟ - has

lingered around the 20 mark for the last fewmonths as investor complacency fed its way intothe financial markets. This was somethingDavid Rosenberg pointed at early last month,suggesting a ‘corrective phase‟ was impending-and this week the ‘ phase’ began as complacency

got shaken out the market.

As the diagram shows, VIX activity soared by55% in the third week of January with calloptions amounting 1.66m and put options524,108 as investors attempted to hedgethemselves as policy confusion gripped themarket. Investors fretted about the impact of theObama administration's proposed restrictions onbanks and the fate of Federal Reserve ChairmanBen Bernanke and as a result, option buyersbetted that markets were going to decreasefurther and so they bid up prices in order toprotect their assets.

Herb Kurlan, Chief Executive of Vtrader Prosuggested that; "The VIX is just reflecting the

troubles in the financial stocks and how it is

going to affect all the market. That is why we

are seeing such a big jump". While I do agreewith this statement, I feel that Kurlan missed animportant point. The VIX index represents whatinvestor’s perceive to be trouble within themarket and based on how they think the marketwill react to certain events.

This is captured by comparing the VIX index tothe S&P volatility index which is shown in thefollowing diagram.

By comparing the implied future volatility of theVIX to the actual S&P 500's volatility, it'spossible to gauge whether the optionsunderlying the index are cheap, expensive orfairly valued as a group. As a result, it's alsopossible to judge how traders and investors viewthe trading pattern for stocks.

When U.S. stocks swooned in the third week of January, the VIX jumped far more than the S&P500's volatility did as reflected in the graph

above. The S&P volatility was at 15 whereas theVIX index exceeded 27. What this conveys isthat investors perceived a danger that did notcorrelate to the actual markets. As DavidWilson from Bloomberg said to me in an email;„It appeared that people anticipated bigger swings in stocks would persist. When they

didn't, the VIX settled down a bit.‟ Essentially,the comparison shows the interrelationshipbetween expectations and reality.

Interestingly, the VIX index has began in recentmonths to realign itself to the volatility in thebond market. There seems to be less of adiscrepancy between the bond market-represented by the MOVE index and the equitymarket reflected by the VIX index. In fact, thereis the lowest spread since late 2007 and thecorrelation between the two indexes hasincreased by 220% since September 2009. Whatthis seems to indicate in my view is that themassive government debt which had initially

put fear into the bond market is now feeding itsway into equity markets.

The Fear gauge In this era of political uncertainty and worry over sovereign risk, doubts about the global recovery have resurfaced

and volatility has returned with a vengeance. This development is captured by the VIX index and this article gives a

brief look into why. By Miles Hamilton




The VIX index has come under criticism lately,for being a ‘ pedestrian measure‟ as TobiasLevkovich remarked, suggesting that it has lostits power on the basis that it signals too late forinvestors to respond meaningfully. I disagree

with this, however, as it is by the very nature of volatility that it ‘occurs in regimes, meaning

that it is persistent through months of time as

information is disseminated through the market‟ (SurlyTrader). Ultimately, the VIX index hasstrength as a measure that shows what investorsexpect to happen within the economy. ■

As the economic recovery gains momentum,individuals seem to have become increasinglyconcerned that consumer price may be poised toincrease. This has manifested itself in the spreadbetween nominal and inflation linked bonds. Asinvestors have begun to fear inflation, they haveinvested in index linked bonds which hasincreased prices and lowered yields relative tonominal bonds.

Thus, as the graph above shows, the spread -also known as the breakeven inflation rate- hasincreased, indicating that people seek protectionby index linked bonds from inflation risk. Thiswas recently shown in the Markit/ YouGovsurvey which concluded that „ 80% of those

surveyed expect average prices to be higher oneyear from now’. (Self, A. 2010).

The result is that the breakeven rate hasrebounded to levels that prevailed prior to theSept. 15, 2008 collapse of Lehman Brothers.“These movements are signalling that inflation

is starting to become a focus in the market,

particularly over the medium term,” saidMichael Pond, Barclays Plc.

The reason why inflation is suddenly cominginto focus is highlighted by Robert Johnsonfrom Morningstar. He reproduced thegovernment's list of inflation by category-shown in the table below- arranging the listsfrom deflationary items to the ones with thehighest rate of inflation. He noted that many of the items on the list have values above 3% but

these are suppressed by the ‘tame’ shelter category which has the largest weight in theindex. With heightening demand and overperformance in the manufacturing sector, theshelter category may not be able to suppressinflation any longer. ■

Dec. 08 to Dec. 09 Price Increases %

All Items 2.7

All items less food and energy 1.8

Utility (piped) gas service -18.1

Food at home -2.4

Electricity -0.5

Shelter 0.3

Food away from home 1.9

Apparel 1.9

Medical care commodities 3.3

Medical care services 3.4

Transportation services 3.9

New vehicles 4.9

Fuel oil 6.5

Used cars and trucks 9.2

Gasoline 53.5

Inflation?

With the V.A.T. increase not only individuals but

the market seems to be hinting that inflation is

imminent. By Miles Hamilton




The theme for 2010 and the rest of the decadelie in currencies and commodities. The inflation

trade is coming back as governments frightengold bugs and bond vigilantes by printingmoney to pay the bills. The word on the street isthat gold is in a bubble. Various commentatorsfrom Nouriel Roubini to George Soros haveexpressed this view. The table below shows alist of 10 precious and industrial metals. Thosecalling a bubble in gold clearly have not donetheir homework. Out off all the metals gold is infact the laggingperformer, rising

only 24% in ayear compared tocopper andpalladium whichhave had tripledigit advances.This newspaper disagrees with Roubini andother market commentators who have repeatedlysaid gold is in a bubble. Just from usingeconomic logic it is almost inevitable that thedollar will decline in the long run. Seeing asthere is an indirect correlation between the valueof the US Dollar and the price of gold, the longterm outlook for gold is strong. Currently theUS dollar has rallied somewhat due to theproblems in Greece and the vulnerability of theEuro. This has led to a correction in gold and ledmany to call a premature end to the gold bullmarket.

The table above shows a brief overview of theprevious gold bull market of the 1970s and the

significant rises that occurred during thisinflationary period. 1971 was the year that theworld’s monetary system was placed purely on a

fiat paper money system when the internationalgold standard was abolished by Richard Nixon.During the 4 years leading up to 1974 goldrallied 471% only to then have a two yearcorrection of 50% when many thought the bullhad died. Those investors that hung on to theirgold holdings gained a further 750% as thedollar declined. Compared to the 1970s run, thecurrent bull market is still in its infancy. Withgovernments and central banks following a

policy of currency debasement, gold andcommodities are the only sensible place to

invest.

The U.S. dollar index has dropped 7.25% in thespace of a year (as of February 3rd). Meanwhile,gold is up 24.2% from a year ago. In otherwords, for every 1% drop in the dollar index,gold has risen 3.35%. If that approximatepercentage holds over time, one can begin toestimate what the gold price might be if youknow what the dollar might do.

The long-term fate of the dollar has alreadydried in cement. If the dollar weresimply to return to itsMarch 2008 low of

71.30 this year or next – an 11.4% drop fromcurrent levels – this would imply a rise in goldof 38.19% and a price of about $1,544 an ounce.Many analysts claim a price of $2000 an ouncefor gold is absurd, but this price is not a radical

assumption. This price can be easily reachedover 10 years if gold rises just 5-6% a year. Inreal inflation adjusted terms, the gold price hasstill not breached its all time high of $2189 thatit reached in the 1970s.

Trade of the decade Many market commentators argue that Gold is in a bubble, but this article questions that position suggesting

that it is relatively undervalued considering its potential strong long-term outlook. By Adrian Booth




The chart above shows the real and nominalvalue of gold going back to 1913. It is hard toargue for a gold bubble when the metal hasfailed to breach its all time high, the price risehas been moderate and central banks are

engaging in risky monetary experiments thatthreaten the value of paper currency. Gold hasbeen currency for thousands of years and is duefor a comeback. The investment battlefield overthe next decade will be fiat money versus gold.Every paper currency in history has crashed andbecome worthless; this time is no different. Wecan expect further turmoil in the currencymarkets and a rush to gold and precious metalsin the next decade. ■

As the result of a post-New Year sell-off, Goldand oil have both fallen in value. Crudecontracts are off nearly $8 a barrel, or 9.5%,

since the top of the year; spot gold's slippedonly $16 an ounce, or 1.5%. This is reflected inthe gold/oil ratio which now stands at 15meaning that an ounce of gold can now buy 15barrels of oil. This is a more sustainable levelthan the 27- 1 a year ago.

As of January 29th 2010, the price of crude oilstood at just over $74.43 a barrel. In relation to

the $125-130 heights and ($40 low) of 2008,

this price can be seen as a return to the stable,gently rising, two-figure normality of 2007.Oil prices in the US fell more than 8 percent inJanuary, pressured by weak energy demand,worries about fiscal turmoil in the eurozone

countries and a stronger U.S. dollar. The USdollar broke out of its trend tunnel, as the graphbelow shows in mid December, risingsubstantially throughout January as investorssought the safety of the dollar.

As the dollar gained value, oil prices fellbecause the higher dollar made the dollar-pricedcommodity more expensive for holders of othercurrencies, contracting demand.So, we feel that oil is underpriced consideringthat a barrel of Perrier sparkling water would setyou back $300 a barrel and a Starbucks Latte insuch form would be priced at $920 per barrel.Coupled with the likely supply restrictions towhich OPEC may agree (due to the breaches of

Nigeria’s supply increases), oil may well be a

worthwhile investment. ■

Black and yellow gold In the previous article it was made clear that

gold has fallen in value, but it is oil that has

suffered worse price falls. By William Whyte

and Miles Hamilton

Interesting fact: why oil is measured in barrels.

Strictly speaking, a barrel should be exactly 42gallons, no more, no less. As they are often metaland sturdy, they were perfect to contain oil whenfirst drilled, because, if the Daniel Day Lewis film‘There Will Be Blood ’ has taught us anything, once

you find oil, it erupts out of the grounduncontrollably and must be containing as quicklyand easily as possible in durable, divisiblecontainers. Obviously once traded, a standardizedsize container was inevitable, and 42 gallons wasagreed upon.




With governments running large fiscal deficitsto help support their economies, as well as

expansionary monetary policies, there has beena growing concern over the credit worthiness of government finances. The risk related tosovereign debt has affected many countries,however, It is clear that the risk affectingGreece because if its debt levels is muchdifferent to that of the UK. Thus, what isessential is a distinction between the risk of default and price risk.

Greece and the risk of default

With Greek bond yields up more than 150 basispoints in a month, it has become clear thatinvestors have factored into Greek bonds asignificant default risk. In fact, Greece isoffering more yield than investors demand fromemerging-market borrowers including Vietnamand Indonesia to sell its first bonds of the year,according to data compiled by Bloomberg.Ironically, it seems that the same mistakes thatwere made lending money to less than qualifiedmortgage borrowers are now being madelending money to less than qualified nationborrowers.

On the 26th of January, Greece successfully sold €8bn in new bonds to investors, however, aweek later prices collapsed and yields increasedto 6.50%. The reason behind this is that “many

of the investors were 'hot money' funds that

bought on rumors that China was emerging as a

buyer, offering them a chance for quick profit.When the China story was denied by Beijing

and Athens, these funds rushed for the exit ."(Marc Ostwald, from Monument Securities).

The result, as the above graphs shows, was thatthere was a rapid deterioration in the perception

of Greece’s credit quality and so credit defaultswaps on Greek government debt climbed to anall time high of 378.5.

Greece is running a budget deficit of 12.5%which far exceeds the 3% that they are supposedto keep to under the Maastricht Treaty. This is aserious problem and it is highlighted by the factthat its current €254 billion of debt is 5 times

the level of Russia when it defaulted on its debtin 1998. Greece’s GDP was €240 billion in

2008 and so it is clear that it has a debt to GDPratio of well above 100% which exceeds the60% limit of the treaty.

In the past, investors have had confidence inGreece because of its presence in the Euro zoneand now that confidence is eroding daily. Theimpact that this has had on investors can clearlybe seen in the value of the Euro.

The graph above shows the Euro against theDollar and how the Euro tracked the fiscalconcerns linked to Greece represented by thesubstantial decline in the latter portion of thegraph. Caused by the relentless selling of Eurozone debt, the devaluation of the Eurofundamentally underscores the decline ininvestor sentiment and faith in Greece’s f iscalposition. The surge in credit default swapscoincided with this devaluation as investors

Tainted as the „New subprime‟ by Gilliant Tett, the growing concern over sovereign debt has lead to increasing risk of default. This article, however, distinguishes between two key risks that are prevalent in the markets; default and

price risk. By Miles Hamilton

Sovereign Risk




sought to hedge from debt using the CDS andfrom the Euro by switched to the safety of theUSD.

Nevertheless, the government of Greecerecognized that it could not continue to run suchhuge deficits. They have developed a plan thataims to narrow the shortfall from 12.7% of output to 8.7% this year. Professor PhilipArestis and Theodore Pelagidis believe thatGreece can achieve this plan and they suggestthat most of the articles published recently inthe press ‘exaggerate Greece‟s economicmisfortunes and underestimate its prospects‟ .They contend that data shows that direct taxesin Greece as a percentage of GDP are around

6% lower than other countries and they suggestthat if this was to be utilised by a tax increase,there would be an increase in tax revenues of

€16bn.

Ultimately, the fate of Greece will be decidedby how investor confidence changes from now.If the Greek population lose confidence to thepoint that they liquefy or transfer their savings,then there may be bank runs in Greece.However, if confidence is rooted in theEurozone is retained then European policy

makers could still have an opportunity to find asolution to Greece’s problems. According to the

Monetary Affairs Commissioner JoaquinAlmunia the latter will be the case and "Greece

will not default” because “In the euro area,

default does not exist."

UK and the price risk

While the UK has an intractable fiscal position,the result has not been a huge loss in confidence

in the UK’s solvency. Rather, the risk that isprevalent in the UK is the risk with respect tobond prices. As J. Grant stated "There is no such

thing as bad bonds, only bad bond prices".

This was underscored by Warren Buffett whowarned that owning government bonds is noriskless enterprise, writing that, "clinging to ...

long-term government bonds at present yields is

almost certainly a terrible policy if continued

for long." The reason for this is that the asset

purchasing scheme has been pushing up bondprices to artificially high levels leading to a

pricing distortion with the government bondmarket. Prices have been underpinned by thefact that investors have had a guaranteed buyerof gilts from the asset purchasing scheme andtherefore, many expect that when the scheme is

finished prices will readjust and fall.Government bonds yields, thus, seem to reflecthow they are ‘risk free‟ in their return but howthey could be toxic in their supply.

Supply is a crucial factor and I feel that it willbecome instrumental in the future. Currentprices seem to only reflect the involvement of the asset purchasing scheme but as RobertStheeman has suggested, when this iswithdrawn and the execrable finances are then

the main price determinant, prices will besubstantially depressed. This could be a problemif investors think the level of debt isunsustainable because it could lead to massselling which would depress prices. As GaryJenkins stated; ‘The biggest single risk hanging

over the bond markets is the rapid rise in public

debt ’ (Oakley, T. 2009).

Ultimately, there is a distinction between thesets of risks faced by the UK and Greece

however, they underscore an important pointthat they root from the same fundamental

problem. ‘The lasting legacy of this crisis is too

much debt held by too many sectors against too

little capital.‟ (Andrew Haldane of Bank of England) ■




The main theme in the markets remains the exitstrategies of central banks. To explain what’s

currently going on in the money markets wemust refer to the following charts.

The chart above shows the monetary base of theFederal Reserve. This is all currency in theeconomy plus reserves with the central bank.When banks deposit money at the Fed, thisshows up in what’s known as excess reserves. In

normal times this is usually $1 billion, as shown

by the second chart. It has now exceeded $1trillion, an abnormal figure.

In normal times a rapid increase in the monetarybase, also known as narrow money, would leadto inflation. Because this money is not being

lent out and is on deposit with the Fed, the risein narrow money is not leading to a rise in other

forms of money supply. In other words, it’s notmaking its way into the pockets of consumers.

But why would banks keep reserves on depositwith the Fed? One reason could be that they feelapprehensive about the economy and refuse tolend money out for fear of losing it. The otherreason is that the Fed is literally bribing thebanks to not lend money out by paying theminterest on these reserves, a policy BenBernanke, Fed Chairman, initiated back in 2008.

For those who think that policymakers are doingall they can to boost lending, ask why would theFed pay interest on these reserves. Eventuallybanks will begin to lend this money out, whichwill lead to severe price inflation if the Fed doesnot act quickly enough. But the longer the Fedpays interest on reserves, and the monetary basegrows exponentially, the problem is only goingto get worse as time goes on. ■

The exit strategy of banks is a key issue, however, it is one that could be exacerbated in the long run if the

Fed carriers on paying interest on reserves. By Adrian Booth

Waiting for the exit

This article features views and ideas that intend to give asubject account of market events. Thus, they are purely anexpression of opinion.This article is the property of Cass Business School and isintended for the exclusive use of students and teachers ofCass Business School. Unauthorized reproduction ordistribution of this material in whole or in part is strictlyprohibited. Please consult Miles Hamilton for furtherinformation;

Email: [email protected]

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