Sunday, March 27, 2011

The Bernanke Put and Volatility Collapse: A Look at the Vix and 2 Year Swap Spread

The slow melt up in US markets has been nothing short of astonishing. Global unrest that would have resulted in market sell-offs in the past have been shrugged off as non-events. Like a sailing ship depending on favorable winds, market bulls have continued pushing equity indices ever higher despite sighting multiple rocky shoals.

Political unrest in the MENA (Middle East North Africa) region, continuing EU insolvency, and higher commodity prices (particularly in fuel and food costs) have all been sighted and then dismissed as unimportant in the greater scheme of things. The force behind these winds has of course been Ben Bernanke's intervention on the markets, primarily in the Federal Reserve's Quantitative Easing programs (QE 2.0 announced last August) but also the continuing legacy effects in the distressed debt markets and cross currency swap programs w/other nations. The financial press has dubbed this combination of corollaries the "Bernanke Put" after the calming effect the Fed Chairman has imparted on market volatility.

The Bernanke Put's most dramatic effect has also been its most recent. The S&P 500 Vix which is a widely used indicator of volatility among buyers and sellers of US equity options saw its most dramatic decline in percentage terms on a weekly basis and its second biggest closing drop since the Japanese tsunami, earthquake, and nuclear meltdowns of March 16. The financial blog, Zerohedge, documents the event here while leaving the implications open to readers. Never mind that the effects of widespread nuclear radiation over an entire country are still unclear - the markets had already dismissed Japan as a non-factor going forward.

At this point, the technician in me feels the urge to add a few comments. I have pulled up my own daily chart of the Vix. Note the steep decline in the Stochastics which indicate a potentially oversold condition. Also noteworthy is the dramatic climb in the Standard Deviation. But pull back and examine the Vix on a longer horizon. While the Vix has experienced a dramatic fall, the charts indicate that there is further room for volatility to collapse.

My own thoughts are that volatility has collapsed too fast and too soon. Yet, I am also hedging my statements by indicating that there is further room to drop. On a historical basis using the benchmark of the past 4-5 years, the Vix has bottomed out at around the 15-16 level. Some readers may object that this time frame is relatively short. If so, they are welcome to expand their charts to as far back as 1995 (when the current Vix methodology was put in place).

But premiums on out of the money puts below the 15 level indicate that market participants don't really believe volatility can collapse much further. This is an implied floor. I think its safe to say that going long volatility (e.g. by buying future month calls) at those levels would be a relatively opportune bet on a risk/reward basis. Options premiums would have declined to sufficient levels to make such debit transactions relatively affordable. Note that this is pure speculation and not really a hedge. The options holder is still exposed to theta, or time decay. The Vix also signals a potentially overbought and oversold conditions among equity markets whenever it has advanced/declined by more than 25% on a weekly basis and more than 15-20% on a daily basis. Speculators can also play the reverse side by buying puts and/or selling calls once volatility has advanced by such levels.

But the S&P 500 Vix is not the only indicator of volatility. The CBOE (Chicago Board of Options Exchange) has been busy developing its proprietary Vix indicators for other volatile underlying assets such as (in no particular order) gold, oil, and now individual stocks. These instruments are all still relatively new and do not have the track record of the S&P 500 Vix so I do not readily follow them. Still I have mentioned them as an objective measure to be inclusive.

Another volatility indicator to follow is the 2 year swap spread (or 2YSS for short). The 2YSS measures the yield difference between 2 year interest rate swaps and 2 year Treasury notes. (Treasury notes are used as a benchmark for risk free rates b/c of the dollar's role as the only global reserve currency). The 2YSS is not as widely known among market followers as the Vix. However, it is a widely followed indicator among bond traders. Interested readers can obtain delayed data from Bloomberg's web site here here. Otherwise, real time streaming data requires access to a proprietary Bloomberg terminal.

Note that the 2YSS barely budged during the 2 week period of March 13-26. Thus, there was room for a fair bit of arbitrage trading between the equity, bond, and volatility markets. The last time it peaked was during late November/early December 2010 based on refinancing fears of the upcoming 2011 mortgage resets and fears of fiscal insolvency among US state and local governments as measured by municipal bond fund outflows. These fears were quickly quashed by additional Fed intervention and Congressional extension of additional tax cuts for another 2 years. Before this period, the 2YSS experienced its greatest volatility spike during the Greek budget Eurozone crisis of late May-June 2010 (which coincided interestingly enough w/the Flash Crash among US equities).

All this pondering on market volatility brings me to my final point. When will the Fed stop intervention? The short answer is: not anytime soon. But a more detailed explanation centers around speculation about the extension of Quantitative Easing 3.0 when the current operation is set to expire at the end of this June. Famed bond guru, Bill Gross, of PIMCO publicly stated that his fund had dumped its entire Treasury holdings in expectations of an end to Quantitative Easing.

Mr. Gross was not the only famed investor to publicly speculate on interest rate flows (readers more interested in Gross' thoughts can find out more here). Insurance companies and corporate CFOs are also rotating out of longer term US paper into shorter term maturities despite the paper losses they may take.

Sovereign holders of US debt such as Japan are believed to be in a position to temporarily stop or at least delay the purchase of additional US debt - especially in light of the massive amount of capital required to pay out insurance claims and reconstruction costs. A large part of the bill will be sponsored by the US and other wealthy nations but an already indebted Japan can ill afford to take on more debt. America's largest creditor, China, had already been on track to diversify its holdings of US debt. It is joined by oil exporters in the Middle East. The common unifying theme among these central banks? A push into gold and silver as reported by the Financial Times. Still, this should not be considered a carte blanche by China and Japan to eliminate US debt purchases. The basic public policies of both countries centers on ensuring cheap exports to maintain political and economic stability.
Eventually, the question will become not who is willing to buy US debt, but at what price and yield.

The Bottom Line: 1) Examine both the Vix and the 2YSS for arbitrage opportunities to go long or short among related risk assets and/or even volatility itself. 2) Quantitative easing is widely predicted to end by June 2011. Many market participants have already begin the process of rotating out of longer term US debt.

Saturday, March 26, 2011

Japan Has Run Out of Bullets - The Implications of Joint Intervention

In an earlier post, I had opined on whether it was time to buy Japanese securities after the immediate effects of the tsunami, earthquake, and nuclear meltdowns. At the time, I believed government intervention was possible - indeed even likely. However, I had not reckoned on the extent of intervention.

For years, analysts believed that the Japanese authorities had been rendered powerless from perpetual deflation as expressed in near zero percent interest rates. With rates already at record lows, there was no further room to cut and bond bears eagerly gathered around the short JGB (Japanese government bonds) trade. But instead of rates rising, the central bank was able to maintain rates at record lows for years and frustrate the shorts. The reasons behind this anamoly are two fold - one, most of the demand is domestic and two, regulatory barriers discourage foreign speculation. Indeed, Japanese corporations and elderly pensioners are sitting on an estimated cash hoard of at least ¥1,500 trillion ($18 trillion) of savings. But that was before the natural disasters of mid-March.

The worst two-day rout in 40 years caused a 6.2% drop in Nikkei share index, wiping £90 billion (roughly $145.45 billion) off stocks. The yen rally to a postwar high of
against the dollar of Y76.25 on March 16. In a desperate attempt to stabilize the markets, Japanese authorities printed an astounding amount of money. The numbers are mind boggling - 15 trillion yen ($183 billion) in liquidity during the first week and then an additional 13-15 trillion yen in the following week for a total of 28-30 trillion yen. The BOJ also intervened in the currency markets by selling over
Y2,000bn ($25bn) against the dollar on March 18. Other central banks followed in an extremely rare joint operation. Japan has essentially run out of bullets and is now borrowing cartridges from other nations.

While the exact amount of currency sold to weaken the yen is unclear what is clear are the implications behind the currency operations. In the past year, myself and other pundits had mused that the G20 was the new organization that had superceded the G7/8 in influence (Canada was the last member to be invited to join) after the financial crisis of 2008-2009. The interventions of mid-March proved that the G8 economies (USA, Great Britain, Canada, Italy, France, Germany, and Japan) continue to retain considerable power in world financial markets. While emerging markets such as China, Brazil, India, and (arguably) Russia are leading world growth, the centers of financial and political stability continue to emanate from the developed world.

The takeaway message here is that more - not less - government intervention is here to stay for the foreseeable future. Even though individual governments may have exhausted their own financial resources they can rely on tools such inter-bank swaps, forwards, and no interest loans (to name a few) from other nations. World governments have learned from their lessons in 2008 and 2009 that coordination is essential to bringing stability to financial markets. This has important implications for volatility and the Bernanke put in the coming months. But that is a topic for another time.

Friday, March 18, 2011

The Chinese Position on Libya

It should come as no surprise to China watchers that the country has followed its historical pattern of abstaining from voting on critical UN resolutions. I speak of course of the current Libyan crisis and the UN vote on a "no fly zone." For the most part, this was a reasoned policy balanced on its lack of influence in certain volatile parts of the globe. What is the point after all, leaders reasoned, of interjecting themselves into a volatile part of the world that has historically captivated the West and three monotheistic faiths? For example, China has famously abstained on UN votes in nearly all Middle East centered resolutions such as both Gulf Wars against Iraq. However, in the present situation, that same line cannot be used.

The Chinese presence in Libya was substantial - comprising tens of thousands of workers in petroleum extraction, refining, transportation, logistics, and engineering. Additional workers were active in construction and mining. Indeed, China was Libya's primary customer for oil and natural gas exports, superseding even the EU as a customer base. In the immediate days and weeks of the initial protests, Beijing reacted swiftly and decisively by withdrawing nearly all of its staff in a massive evacuation operation to protect them against political violence. No expense was spared in round the clock airlifts, boats, rail lines, and buses to evacuate nearly 36,000 Chinese citizens. The official China news agency, Xinhua called it "a decisive success in China's largest-scale overseas evacuation since the birth of new China in 1949." The reaction was a shrewd one given the rebels' treatment of loyalists and government allies - namely the violent street justice executed against "African mercenaries" hired by the regime. In any event, the operation was a combined military and civilian effort that was swift, orderly, and above all effective in comparison to the chaotic and often ad hoc efforts of other nations.

Now that its citizens have been largely evacuated, China is now in the difficult position of balancing its strategic energy policies against its role as an emerging global power in international relations. The cozy relationship between the Politburo and Muamar Qadafi would surely come under intense scrutiny and perhaps even be jeopardized by any new regime. Several rebel spokesmen have already threatened to cut off ties w/Qadafi's business partners, a thinly veiled allusion to China. Although the exact amount of capital invested in Libya is not readily available to the public, Beijing has surely spent an enormous amount of money, time, and resources in cultivating a decades long working relationship with the country's leadership. This relationship in turn was founded in the shadow of numerous Western sanctions against Libya in the 1980s and 1990s for Libya's erratic actions such as sponsoring terrorist groups. Qadafi himself has seemed to turn on his erstwhile (unnamed) business partners and condemned them as cowards for abandoning him so quickly. In that light, the Chinese actions can be viewed as a poor attempt to ingratiate itself with both the West while preserving its investments in Libyan soil.

Or perhaps I am being too critical of Beijing. After China's initial opposition to the 2003 invasion of Iraq due in no small part to its substantial investments w/the Saddam Hussein regime in infrastructure, personnel, and logistics, Chinese firms were able to move back into the energy market by working w/the new US/British run government. Perhaps a similar event would occur again.

The successful model for a no fly zone can be found in the 1999 NATO campaign against Serbia. But even this is an inaccurate description. While the political talking heads intended to start by owning the airspace over Serbia, it quickly became apparent that they needed to escalate their selection of targets beyond mere air fields and radar sites. Strategic targets - including those of no military value - were quickly added. Bridges, roads, power stations, broadcasting towers, and government party buildings were all added to the list. Air strikes were eventually coordinated w/ground assaults by the separatist KLA (Kosovo Liberation Army). In a similar vein, any air campaign against Libya would become a de facto air arm of the rebel army. Add to that mix that even the rebels are unsure who is in charge and we have a recipe for political disaster akin to the situation in Iraq following the deposing of Saddam Hussein. So, perhaps the Chinese are right after all to be cautious. Still, the threat of prolonged air raids may be enough to move Qadafi to the bargaining table. Indeed, the no fly zone's political value may supersede that of any military one. It is even possible that a partitioning of the country may emerge - the rebel held east (full of oil) and the more urban west (not so full of oil).

Tuesday, March 15, 2011

Is US Farmland a Bubble?

A few days ago I posted about rising agricultural land values in South America. Well, here is a look at the US market. While the US continues to suffer from prolonged deflationary effects in residential and office space, agricultural land values have soared. Is this a bubble too? Only time will tell. But the year long surge in corn, wheat, and soybeans - some by over 100% - means a correction has been in order for some time now.

Farmland Fund Expects Prices To Keep Soaring
Cheap farmland is hard to find.

Values in Iowa and other key agricultural states jumped 12% in 2010, the second-biggest increase in the past 30 years, according to the Federal Reserve Bank of Chicago.

Nationwide, prices have doubled during the past decade and climbed about 58% when adjusted for inflation, U.S. Department of Agriculture statistics show.

Still, Greyson Colvin is hunting for deals as managing partner of two farmland funds for his agriculture-focused investment firm Colvin & Co., which aims to acquire undervalued properties.

"The farmland market is certainly tighter than it's been over the last 12 months," Colvin acknowledged.

Colvin manages about 1,500 acres of farmland in South Dakota and Wisconsin, worth $7 million, in the Sather Agriculture LP fund, along with about 350 acres held in individual accounts. The fund, which was launched in 2009, had a return of 29.6% in 2010, up from 7.8% in 2009, according to the company, compared with 15.1% and 26.5%, respectively, for the S&P 500.

There are signs investors will continue to reap gains from the sector, Colvin said. He touted farmland as "the one element that you can't replace across the agricultural equation" and said rising global demand for meat will keep pressure on growers to increase production of grain, which is used to feed livestock.

The company targets land that produces corn and soybeans, the dominant crops in the fertile Midwest. Colvin and his brother-in-law, an associate in the company, inspect properties personally before making purchases to check their quality.

He scoffed at observers who warn soaring land values may form a bubble. Agricultural fundamentals are the best in decades, he argued, saying rising farm income and cash rental rates justify the appreciation in farmland.

"We really believe that farmland is actually underpricing commodities at this point in time," Colvin said.

Indeed, farmers have the potential to cash in big on coming harvests, as corn, soybean and wheat futures recently surged above 2 1/2-year highs on concerns about tight supplies. Domestic corn inventories are expected to plunge to a 15-year low by the end of the crop's marketing year on Aug. 31 due to strong demand and a disappointing harvest last fall.

If cash prices for corn, which is trading around $6.20 a bushel, remain above $5 at the end of the year, Colvin said farmland values should be up an additional 10% to 15%. The outlook for corn prices is uncertain because farmers are projected to harvest a record crop this fall to replenish supplies.

Source CME News for Tomorrow

Is is Time To Finally Short JGBs and Buy Equities?

JGBs or Japanese government bonds, have been in a bull market for years. Near zero percent interest rates leave bonds with no more room to advance and is in large part, blamed for much of the financial malaise that has gripped Japan for the past generation.

In response to the devastating earthquake, tsunami, and multiple nuclear fallouts, the Japanese government has unleashed a massive spending program on an order that would make Ben Bernanke proud. Trillions of yen are being printed to address the short term liquidity crunch, pay for much needed repairs, and to support equity markets. (Note - While I do not intend to downplay the human toll of recent events, this is a blog dedicated to financial speculation and its ripple effects. It is possible to be both humane while still sticking to the original mission statement).

But even before the recent catastrophe Japanese public finances were in a dismal state. With public debt to gdp approaching 230% the JGB bond market had attracted the attention of bond vigilantes eager to short. In comparison, the US debt level is closer to 95%-100% (depending on which source you rely on).

While these bond bears had initially arrived in the early to mid 1990s following the dramatic Japanese market corrections and property bubble, most had moved on to greener pastures, unwilling and/or unable to fight the firepower of the Japanese central bank. Other bears switched to the increasingly lucrative forex trade where they sold the low yielding yen to buy higher interest bearing currencies like the Aussie, Real, and Kiwi.

In the intervening years, Japan continued to wallow through deflation. Its ranks of elderly grew while the number of young people shrank. These members of the "lost generation" became disaffected by societal changes beyond their control. Many became "otakus" or socially ignorant shut-ins whose only refuge was the Internet. The complete lack of job security for young workers who can only find temporary employment has made life difficult for new families and caused the birth rate to be cut in half (job openings are restricted to care for the ranks of middle aged and elderly that were promised a cradle to grave existence by prior managements). Society became more insular and engrossed in domestic affairs.

Nowhere was this demonstrated more dramatically than last year when China overtook Japan as the world's 2nd biggest economy. But even this event was noted with weary resignation by a population already accustomed to a diminished role on the global stage.

So, will the recent turn of events cause them to return? The short answer is possibly. But not right away.

Rising bond yields are correlated with rising equity markets. Or are they? In the months following the Kobe earthquake of 1995 the Nikkei continued to slide. The Topix bottomed out in June 1995 (Japan's largest index after the Nikkei, similar to the rivalry between the DJIA and the S&P 500). Even the Nikkei failed to regain its pre-2008 highs. Japan's government has traditionally been able to rely on domestic consumption to finance most of its needs. This is a generalization but foreigners find it difficult to engage the non-Japanese investor. Companies and families are now faced w/the prospect of liquidating their assets (including JGBs) to pay for much needed supplies like food, water, and housing - not to mention the enormous debris clearance and reconstruction efforts. Some bears are beginning to awaken from their hibernation, entranced by the prospects of JGBs achieving junk status in the near future.

But the BOJ has never intervened on a scale like this before. Additionally, the worst effects of persistent deflation seem to have been priced out. Indeed, the effects of deflation are so strong that JGB yields are STILL implying zero inflation despite oil >$120/barrel and staple food prices advancing over 150-200% in a year!

Risky Business in Asset(less) Lending

Retail investors have been on a hunt for debt based yield ever since Bernanke announced QE 2.0 last year. However, most bargains had already been snapped up earlier in 2009 by savvy fund managers. Most of the best issues have already been priced out of the market as reflected in lower interest rates. This was a win win situation for both debtors and lenders as the former were able to refinance at a critical time while the latter was able to achieve impressive gains.

But as the year progressed, less financially sound companies began to seek similar sources of funding among investors. Those who missed the initial rally in high yield issues have piled onto riskier and riskier issues. The principal cases in point are the recent surge in covenant line loans, pik toggles (payment in kind), and other mezzanine based debt structurings.

These types of deals were blamed by some critics for being a harbinger of the financial crisis in 2006-2008. The higher returns being offered to investors are a reflection of the greater risk involved to junior creditors. The most worrying parts are loan provisions that allow a borrower company to default in the event of deteriorating finances or even natural disasters such as acts of god. Unlike senior note holders, junior creditors are usually left holding the proverbial bag in case of a default. They are usually unsecured, or lack collateral, in their underlying loans.

So, what are some warning signs of a potential default? Here is a short list - large borrowings to pay special dividends, large bonuses paid to management, poor cash flow, goodwill comprising an unexpectedly large part of the balance sheet, and potential legal suits.

Saturday, March 5, 2011

The German Success Story

Great article from Time Magazine about how Germany is becoming the success story of the EU. Exports have driven much of the country's growth since the doldrums of post-reunification.,9171,2053595,00.html

Wednesday, March 2, 2011

Chinese Farmland Continues to Experience Dry Conditions

Some interesting news coming out of China. Of particular concern is the wheat crop. 2011's wheat harvest is dependent to a great degree on Chinese output. The problem is compounded by some local governments' insistence on re-routing water tables for industrial use. Winter wheat in particular is very water intensive.

Most Of China's Cultivated Farmland Lacks Irrigation -Official
More than half of China's cultivated farmlands are dependent solely on weather conditions for water, with only 49% served by effective irrigation, a senior Ministry of Agriculture official said in an essay on an academic website.

The government targets spending of CNY4 trillion ($608 billion) over the next decade on water conservation infrastructure projects. It is redirecting $12 billion this year from property tax revenues to irrigation projects and making water conservation the centerpiece of its 2011 agriculture policy.

Zhang Hongyu, the ministry's supervisor of agricultural policy, said on the Chinese Academy of Social Sciences Rural Development Institute website Tuesday that "irrigation is the weakest link in China's agricultural production infrastructure."

Two-thirds of China's farmlands are affected by drought, steep slopes, poor soil, salinity and other factors, he said.

In China, efficient water use through irrigation is just 60% that of developed economies, Zhang said in the essay, without elaborating.

In his essay, which was first published in the Communist Party's People's Daily newspaper, Zhang also called for the government to redirect industrial investments to the agriculture sector to "release the potential of rural consumption."

"The need to expand domestic demand is a basic necessity of improving agricultural infrastructure," he wrote.

Even as rural incomes have risen on the tide of surging agriculture commodity prices, China last year recorded its widest rural-urban income gap since 1978.

Source - CME News for Tomorrow

Tuesday, March 1, 2011

Argentinian Land Bubble?

Longtime readers will know that I have long favored South America as an investment destination for agricultural products. Interest in all things agricultural has only grown with the advent of high food prices.

Type in buy farmland in Argentina on Google and you will face tens of thousands of hits. Most of the results are of dubious value and years old. However, I received a story today from a credible source that is pertinent.

Argentina Should Limit Foreigners' Farmland Purchases - Minister
Pressure is building in Argentina to limit the amount of land that foreigners can buy as record prices for grain and derivative products fuel concerns that deep-pocketed overseas investors might end up controlling a significant percentage of the country's farmland.

Last year, congressmen from a across Argentina's political spectrum sponsored about 12 different bills that would have put limits on foreign land ownership. While those bills are stalled in the agriculture commission of Argentina's lower house, the administration of President Cristina Fernandez looks set to weigh in on the issue.

"[Fernandez] believes that the legislature needs to debate the protection of the country's primary non-renewable strategic resource--the land," Agriculture Minister Julian Dominguez said in a speech on Sunday.

The land "has to stay in Argentine hands," Dominguez said.

Agriculture exports were largely responsible for Argentina's whopping $12.06 billion trade surplus last year, while taxes on farm exports accounted for a significant percentage of the federal government's tax revenue. Argentina is the world leader in soymeal and soyoil exports, ranks No. 2 in corn exports, and third in soybeans.

As global commodity prices soar, investors have increasingly looked to the fertile farmlands of Argentina and Brazil for investment opportunities.

That has helped fuel surging land prices in recent years. At the end of 2010, prime farmland in Argentina's Buenos Aires Province was selling for $15,000 a hectare (2.47 acres), according to local daily La Nacion. That is about double the price in 2007 and over five times prices in 2002 when the country was in the midst of an economic crisis (emphasis my own).

Argentina's northern neighbor, Brazil, has already taken steps to protect its national sovereignty over farmland. Last year, Brazil's former President Luiz Inacio Lula da Silva slapped limits on foreign ownership.

Land purchases involving a foreign investor or a local company that is majority owned by foreigners are now reviewed on a case by case basis. Certain limits will apply depending on the geographic area of the purchase.

A similar law is needed in Argentina, where about 7%, or 20 million hectares, of the country's productive farmland is in the hands of foreigners already, said Omar Principe, who heads the land commission at the Argentine Agrarian Federation. The association, know as the FAA, is one of the country's leading farm groups and represents small-scale farmers.

Source: CME News for Tomorrow

Equity Markets Tends To Rise in March

I suppose I would be remiss if I did not take on the bulls' case. Well, here is an interesting note. The S&P 500 as represented by the SPY etf tends to rise in March. See attached chart. I am unsure for the reasons behind the rise and welcome thoughts.

A closer look at the shorter term charts and other market indicators is warranted before making a decision.

Update - Volatility Where Art Thou?

Wow. I have not posted in a long time. I have been pursuing career development (like opening a law practice) in other areas and relegated blogging more or less to a hobby. To say the world has changed a lot since my last post is an understatement. Instead of giving a detailed chronological account of the last few months, I will jump right in and address the current event topics.

The markets have been on a bullish tear since Bernanke made his announcements of Quantitative Easing in late summer/early fall 2010. Since that time, the bulls have been seemingly undeterred by any bearish news. Even the collapse of two Middle Eastern dictators has not done much to stall their advance. However, there are multiple storm clouds on the horizon that would give even the most ardent among the herd a reason to head for shelter.

I see 2 problems looming, Stagflation and European defaults. Neither of these are new but the context in which they are being presented is changing rapidly.

Stagflation is defined as a combination of weak economic growth and high inflation. It is the one threat that has the potential to impede further progress in equities and other risk trades. After all, the recovery trade is more or less done at this point w/most companies having borrowed to buy back their shares (which is my own belief behind the market's advance). While inflation remains relatively low in the West, it is offset by continuing weak labor markets. Instead, inflation is strongest in emerging markets where food and fuel comprise a larger percentage of residents' budgets.

The fundamentals of higher food prices are linked to dietary progressions up the calorie chain for more expensive items. People used to eating rice and lentils have become hungry for chicken and beef. These added demand constraints on farmers and land use has been further exacerbated by volcanic activity in Kamchatka, Russia and colder weather patterns in the Pacific Ocean. Kamchatka is a remote province in the Russian Far East most famous for its large population of bears and elk. But the same geography that is responsible for its geographic isolation is also responsible for a recent spurt in eruptions that have sent hundreds of tons of soot and ash into the atmosphere. La Nina is a reference to the cooler waters in the southern Pacific Ocean that generally lead to drier weather in North and South America.

As any decent farmer knows, the world turns in cycles. (See some of my past posts on El Nino for example) Most of the seasons can be predicted with a great deal of accuracy. But these additional wild card factors are causing substantial changes in heretofore unforseen ways. The changes have resulted in supply constraints that have sent agricultural prices skyrocketing.

European Defaults

Private creditors are not exactly lining up to buy peripheral EU debt. They have their reasons. A case in point is the recent elections in Ireland that saw the outgoing party, Fiana Fail, lose the most within 3 generations. Irish voters were enraged beyond measure about the party that got them into the current mess and wanted to turn them into slaves to foreign creditors. So, why does an election in a country with a population a tiny fraction of the total EU? EU ministers have been promising that all debts will be repaid. Unfortunately Irish voters basically said NO to that idea with a resounding voice. The new govt is likely to push for
a restructuring - a default in all but name. And when that happens the other PIIGS will also want the same thing. What do you think will happen to the markets when a wave of defaults on that scale occurs?


Ok. Enough fundamentals. Let's talk technicals. After all that's the title of this post. For the purposes of measuring volatility we will look at the S&P 500 Vix (volatility options index). I like the vix because it is about as pure a mathematical indicator as you can get. It has been alternately called the fear index b/c when the vix spikes, it indicates nervousness among options buyers on the S&P 500 stock options prices.

So, how To Protect Against Volatility?

I have put up several charts of the vix which indicate a potential spike in volatility over the next few months. Note the ATR (average true range) and standard deviation indicators. Like all options, vix options pricing reflects market sentiment by the sellers for future months. Outright buying vix options (in this case calls) 3,4,5 months in the future seems feasible at first until you consider that the only way to make a profit on those is by having the rate of change accelerate dramatically (preferably in the near term). To some extent this is true of any options buyer but the vix is different b/c the underlying values change for every month. In turn this is due to reversion to the mean as measured by standard deviation - which is more volatile by far than the vast majority of stocks or commodities.

The vix also spends most of its time in contango - a term used to describe the larger premiums demanded for far off months than compared to near month contracts.(Vix futures can be priced for backwardation but this happens less often - usually when the vix is already flying next to black swans -look no further than the September 2008-March 2009). The reason for this can be readily explained by looking at the vix over a long period of time. While the vix can and does readily revert to the mean, it can spike significantly in the short term and even stay there for protracted periods of time. The higher priced premiums are the result of options sellers demanding suitable compensation for taking on that level of risk.

So, what to do as a trader or even a hedger looking to protect against a fat tail event? In (relatively) low volatility times, debit (put) spreads on index etfs or leading stocks seem to be the way to go. There is limited risk but limited upside (of course the upside can still be considerable). Premium selling strategies are not worth it with low volatility. Of course, one can always buy calls or puts (well in this case puts if you favor a sustained market correction). You still have to be right with both trades (debit spreads and straight options buying) but at least volatility is favoring the options buyers.