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The Daily Reckoning | Monday, March 22, 2010 Financial Fear Factor Why the VIX is set to iInduce worry in the stock market Eric Fry Finally, last Friday, the US stock market snapped its winning streak. Eight winning sessions in a row did not become nine, as the Dow slumped 37 points to 10,742. But even so, the US stock market has been delivering surprisingly strong performances of late, especially when one considers that the economy hasn't been. Day after day, stocks inch higher, despite the fact that the economy merely muddles along. This trading action would seem more reasonable if stocks were cheap. But they aren't. Based on consensus estimates for 2010, the S&P 500 Index is selling for more than 21 times earnings. We use to call that "expensive." Nevertheless, in a world of microscopic money market yields, stocks seem like a less ugly option to many investors. We understand the appeal of an asset like stocks that might deliver SOME return, compared to an asset like one-year T-bills that offer next to NO return. On the other hand, we also understand that the return stocks might deliver might not be a positive one. Sometimes 40 basis points in the hand is better than getting your rear- end handed to you. Your editors are not predicting that the stock market will soon begin to malign investors rather than comfort them, but neither are we ruling out the possibility. We are uncomfortable with the smug confidence that inspires new "buy" orders at 21 times earnings. Now that the S&P 500 has rallied more than 60% in just 12 months, most stocks are probably better sold than bought. "The May VIX is at 21.70, which is 5.10 above the cash VIX of 16.60," observes Jay Shartsis, an options expert with R.F. Lafferty in New York. "The June VIX is at 22.60 which is 6 points above VIX. That's a gigantic premium, and is very unusual. This big premium in the May and June contracts suggests a big jump is coming in VIX...and that means a sharp drop in stocks." The VIX Index, also know as the "Fear Gauge," measures the implied volatility of certain option contracts. As such, it measures the relative fear or complacency of option traders. When the VIX Index is very low, as it is currently, option traders are relatively complacent, which is a danger signal. When the VIX reading is high, option traders are very fearful, which is usually an indication that stocks will soon begin to rise. The observation made by Shartsis incorporates one additional wrinkle: the relative pricing of near-term VIX contracts. These near-term contracts tend to lead the VIX Index. Thus, when a big premium opens up between the near-month contracts and the cash VIX, as is currently the case, the "smart money" is starting to become worried about the stock market. Be forewarned, the smart money is worried...and so are we. Nevertheless, long-term investors will want to read the following column carefully. Chris Mayer returns to share his bullish views on the water sector... The Daily Reckoning Presents Water is Too Cheap! Chris Mayer The city of Milwaukee is starting to figure out it has a great resource in its backyard - access to the fresh water of Lake Michigan. The history of Milwaukee is a history of that plentiful water supply. Water-intensive businesses such as breweries and tanneries flourished here. They helped build this city on the shores of Lake Michigan. By the early 20th century, Milwaukee was the nation's chief brewer. Pabst, Miller, Schlitz and Blatz - they all called Milwaukee home. Things topped out in 1960, and since then, Milwaukee's population has been in decline. The tanneries left. The big breweries are gone. What remains, though, is the water system. Pipes, tanks, pumping stations, treatment plants... Today, it runs at only a third of its capacity. So the city plans to use this as a lure for so-called "wet businesses," or businesses that use a lot of water. Come to Milwaukee and it'll give you a break on water rates for up to five years. The city is not alone. Erie, Pa., has been offering Lake Erie water at 40% off for businesses that relocate there. The fact that Milwaukee and Erie can do this at all tells you something about America's water supply. It is - or is in the process of becoming - unreliable. I've written about this unfolding water crisis for years, and it always interests me. I think water will be one of the most important investment themes over the next decade, at least. So when offered a spot at the Gabelli Water Investment Summit in New York, I duly took it. The folks at Gabelli do a good job of bringing together a dozen or so executives of water companies from around the country. It's a worthwhile day, and I always learn something. I also can't help but come away thinking bad thoughts about the way the US runs it water supply. The most eye-opening presentation was by Nick DeBenedictis, the CEO of Aqua America, which is the second largest investor-owned water utility in the country. (It trades on the NYSE under the ticker WTR.) He gave a good overview of the water utility industry. In a word, I'd have to say "messy" is an apt way to think of it. As DeBenedictis said, "You would never design it this way." First, there are way too many systems. We have 55,000 water systems in this country. Second, most are too small, serving fewer than 3,000 people. The whole thing is inefficient, like trying to sled uphill. But for whatever reasons, most people in this country think access to water is some kind of right and that we shouldn't charge a market price for water. So market forces have not shaped the water industry as much as they might have. In the US, the government runs most of these systems. Only about 10% of the population gets its water from a private entity such as Aqua America. In other parts of the world, the story is different. In England, 100% of the people get their water from private sources, and they have just 10 water systems. Even in France, 90% of the people get their water from private companies. In the US, we let government officials run amok. It was not always so. In 1850, about 80% of the country got its water from private companies. By 1900, it was 50%. So we've taken decades to get where we are today. Where we are today is an expensive place to be. Summit Asset Management recently put out a white paper, The Case for Water Equity Investing 2010. (It's available free on the Web and is well worth the read for the broad overview it gives.) In the paper, the authors sum up the damage. "In the US alone, the network of drinking water pipes extends almost a million miles - more than four times the length of the National Highway System. This aging infrastructure, much of which is more than 100 years old, has long exceeded its useful life and in many areas is in a state of utter disrepair." To fix it will cost at least $500 billion over the next 20 years. That's a lot of new pipes, treatment plants, security upgrades and more. I bet it costs twice that. These projects always cost more when you start digging and pulling stuff out of the ground. You would be appalled at the pictures of government-run water systems, which look like something out of the old Soviet Union. Dirty, old, rusted plants...water pipes filled with crud and buildup...little outhouse-like structures with no security that tap right into the drinking water supply... "Cities around the country are playing the game of pay me later," DeBenedictis says. "Leave it for the next mayor." That's always the problem. Who wants to be the politician to raise water rates to pay for needed repairs and maintenance? And so the systems plunge deeper into decrepitude. The city does nothing until it has to. But the day of reckoning has arrived! To be continued tomorrow... Chris Mayer for The Daily Reckoning Bill Bonner Inflation and the Asian Consumer Boom Bill Bonner Want to get married? Just look in the Bombay newspaper: "Alliance invited for a Punjabi girl, 40/5.5...stammering a bit, physically healthy...totally homely..." Not very good advertising. Probably because they use the world "homely" in a different way... How about this? "Highly affluent cultured Kolkata-based Hindu Agarwal Family (originally from Rajasthan) invites proposals for their 'USA based' daughter. She is fair, slim, smart..." Or... "A Reputed Agarwal family having Established Business of Garment Exports/Builders seek alliance for their Daughter. Fair, Slim, Very beautiful, Convent educated... Boy should be handsome, well Educated/Settled from similar status cultured business family..." The paper is full of possibilities. But it helps to be 'fair'...often described as "wheatish," well-educated... And from a good family. No mention of money. But "cultured" and professional and education figure prominently. So why spend so much effort trying to get rich? All you need is an engineering degree, a masters, from MIT, and you can get a beautiful, wheatish girl from the Punjab.  Wait...here's the money... "Maharashtrian Deshastha Brahmin well-established business family invites alliance for their daughter, fair, beautiful, 28, 4' 11", B.A. Journalism..." wants a qualified, good personality boy...with a minimum income of Rs. 1 Lakh per month." How much is a lakh? More below...  Meanwhile, the Dow fell on Friday. It was down 37 points. Another day older. Another day not wiser. We don't know any more than we did the day before.  Oil fell $1. Gold dropped $19. Hmmm... Inflation? Deflation? Analysts and pundits are trying to look into the future. What's coming? Higher prices...or lower ones? Forget looking into the future. It's hard enough to tell what is going on right now. Our prediction, years ago, was that we would see BOTH inflation and deflation. But even we didn't foresee such a mix of inflation and deflation AT THE SAME TIME. In India, which we left this morning, food prices are soaring.  "Consumer boom drives rapid rise in inflation," says The Financial Times. In parts of India, the price of tomatoes rose 200% in just a few days.  The "inflation genie is getting out of the bottle," is the FT's comment. Worldwide, at the wholesale level, there's plenty of inflation. Oil has gone up 115% since January '09. West Texas Intermediate is now selling for $85 a barrel. Iron ore is up 95% during the same period.  There's also something called the Rind Index that measures the commodities that people don't usually pay any attention to - things like burlap and animal hides. These things are used by industries to make things. There's not much speculative buying. But there's plenty of inflation. The Rind Index is up 50% since January '09. Prices are rising in China too. Guangdong, a large state in South China, next to Hong Kong, has just raised its minimum wage by 20%. Believe it or not, the papers tell of a labor shortage in China. There are said to be some 2 million unfilled jobs in the Pearl River Delta area, says the FT.  (Dear Readers looking for employment might want to think twice before packing their bags and going to China. After the wage increase, the minimum monthly salary in Guangzhou, the provincial capital, is still only 1,030 renminbi...or about $145.) Inflation...inflation...inflation everywhere... But wait. The Fed says there's no inflation: "With substantial resource slack to restrain cost pressures...inflation is likely to be subdued for some time." The Fed is right...as far as it goes. CPI readings in the US are coming in at their lowest levels in six years. Most businesses have plenty of excess capacity. The labor market has 11 million surplus workers. The dollar is strong. China is desperate for customers. Why should prices rise? But that's what they're doing. Rising. And falling. At the same time. Hot money from the feds - and "growth" in China and elsewhere - drive up prices for raw materials... while the Great Correction drives down consumer prices in the US and Europe.  How will this work out? Which one will dominate - inflation or deflation? It depends. So far, the feds are winning their battle - at least on the surface. Stocks are up. Commodities are up. Junk bonds are up.  But we're still betting that the major trend...the deeper and more important trend...is down. You wouldn't know it from reading the paper or watching the TV. On the surface, the crisis is over. And maybe it really is. But it's a bad bet. Because the risk is still on the downside.  If the feds succeed, maybe they can keep the credit bubble - now focused public sector credit - pumped up a bit longer. But so what? What can you win by betting on even higher stock, bond and commodity prices? Probably not very much.  The downside, on the other hand, is like the Grand Canyon...deep...and treacherous... Yesterday, we went to Bombay's street of dreams... It looked to us as though it was more of a street of nightmares. The street was torn up. It smelled of sewage and industrial waste. We looked up and down for the office of a fellow who is one of Bombay's leading authorities on the gold trade. When we finally found him, we had to go through a dirty doorway, past a shop where people were sitting on the concrete floor stuffing mattresses with wool, up an elevator last inspected by the British in 1946...and finally to a tiny little office at the back of the building. "You have to understand," said the slim man with a bandaged foot, "the gold trade here in India is very different than anywhere else. People use gold for household finance. When they need cash, they sell their gold. When they want to save money, they buy gold. And they are required to buy gold for various special occasions too. Weddings, festivals...there are plenty of holidays in India...and each one is an occasion for buying gold. One holiday calls for buying arm bracelets. Another for buying bangles. Rings...necklaces... every bit of jewelry is also a sign of status...and family savings." We went back onto the street...and made our way past porters, shoppers, loiterers, sleepers...over to the jewelry shops themselves. They say the population of India is 1.2 billion people. It seemed like more than that in a three-block area... There is a guard at the entrance to the shop. He waves a wand around our bodies, trying to detect metal or karma, then gestures for us to proceed. In the shop, there are dozens of sari-wrapped women studying the glass display cabinets. Behind them are other sari-wrapped saleswomen, answering questions... "How much is this?" We saw something that might make a nice birthday present or wall display. It was a large, splendidly gaudy necklace of finely-worked gold.  "That's 4 lakh." "Four what?"  "Well, a lakh means times 100." "So, it's 400 rupees?" "No, it's 400,000 rupees." "So a lakh means 100,000?" "No...wait...I read the price wrong. It's only a fifth of a crore, so it's more like 2 lakhs." "What's a crore?" "It means you multiply by another 100." "Oh..." "So, this is 0.2 crore, or 2 lakhs, or 200,000 rupees...?" "Yes, that's it." "And how much is that in dollars?" "I don't know...we only accept Indian currency." Regards, Bill Bonner,  for The Daily Reckoning --------------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com