Britannia Radio

The Daily Reckoning U.S. Edition

Home . Archives . Unsubscribe

The Daily Reckoning | Wednesday, April 28, 2010 Fear is back! VIX jumps most since 2008 as Greece rattles markets, How to make "three or four times your money" trading that fear, Plus, Bill Bonner with a few words on the bumbling "debt panel" and plenty more... ------------------------------------------------------- The Reemergence of Fear Does the spike in the VIX signal the beginning of the end? Joel Bowman Reporting from Taipei, Taiwan... Until very recently - as in, yesterday recently - there appeared to be little worth fearing in the stock markets. At least that's what Wall Street's "Fear Gauge" seemed to suggest. Cautious investors, of course, knew better than to trust their respective governments' ability to do anything other than deepen and lengthen a crisis. Prior to yesterday's 2.3% tumble in the S&P 500, the VIX Index - which measures fear by calculating the price of option "insurance" against future market declines - had meandered into what, historically, has been rather dangerous territory. "Right now, the VIX is bobbing around close to its 18-month lows," your editor noticed aloud in these pages back in mid-March. "That means traders are not forecasting much of anything...a pretty good sign that we'll see quite a bit of something. Last Friday, the measure fell to 17.5, a level not seen since January...when the S&P promptly fell from around 1,150 to 1,050. "Before that," we continued, "the VIX had not seen a reading of 18 since August of 2008...right before the market went skydiving without a parachute. By March of 2009, a few short and painful months later, indexes around the world had almost managed to saw themselves in half...or worse." Determined to battle gravity with complacency, investors continued to shrug off the growing concerns of - among other things - sovereign debt crises during the ensuing month, pushing the S&P 500 higher and the VIX Index ever lower. What goes up, alas... Lo and behold, the financial tragedy in Greece did not simply blow away in the wind. That ongoing fiasco and the associated threat of sovereign default contagion conspired yesterday with the Goldman goings-on to reveal an Achilles' heel in the permabulls' armor. Standard & Poor's, the venerable ratings agency perhaps best viewed as a lagging indicator of creditworthiness, yesterday saw fit to downgrade both Greece and Portugal's sovereign debt rating. At BBB+, Spartan debt is now officially "junk" status, according to S&P; the first time a euro member has earned the dubious title since the currency experiment began. Portugal's rating was also taken down a couple of notches, from A+ to A-. The VIX, predictably, shot up 31% during the session to close the day out at 22.81 - its highest level since February 11 and the largest single-day spike since October 2008. "It's a very big concern," Jon Corpina, senior managing partner at Meridian Equity Partners Inc., told Bloomberg. "It starts off with Greece and everyone looks at the map to see where else it can spread." A tougher question, perhaps, might be where can't it spread. Europe's PIIGS - Portugal, Ireland, Italy, Greece and Spain - are lining up for space at the trough, their muddied snouts in search of handouts and lifelines. How about the UK? Japan? The US? Fuggedaboutit. In addition to terrible finances of their own, the world's most 'advanced' economies are also facing intractable demographic problems, whereby more and more welfare recipients will come to depend on fewer taxpaying contributors in coming years. As it turns out, things can go wrong in happy-smiley markets. Indeed, sometimes they even do go wrong...dreadfully so. We're not quite at the "dreadful" stage yet, not officially...but give it time. In today's essay, our go-to value man, Chris Mayer, returns with some notes on how you can trade the fear in the market and to make it work to your advantage. Please enjoy... The Daily Reckoning Presents Fear is Cheap Chris Mayer Fear gives intelligence to fools, says an old proverb. Turning it around a bit, we might say that lack of fear makes fools of wise men. In the market, fear - or lack of same - finds expression in many forms. The Volatility Index, or VIX, is one of them. Known as the "fear gauge," the VIX bounces up and down based on what people are paying for options on the S&P 500. For example, if people are fearful, they tend to buy put options. Put options are like insurance against a fall in price. They pay off if the market falls. When investors pile into put options, they make the price of such options rise, and that pushes the VIX up, too. Conversely, when people are not worried, they sell those options - or at least they don't buy them. So the price falls, and so does the VIX. There has been a lot of that going on in the last year. The VIX recently hit its lowest point in 30 months, as shown by the nearby chart. Fear looks cheap. Given all that is going on in the world, it is remarkable to find investors so complacent. The financial system is still a rather creaky affair. Leverage is still high. Banks remain undercapitalized. The credit cycle has not yet run its full course, as there are still significant credit losses hiding in the cupboards of banks. Then there are the governments of the world. The US has awful credit metrics. It is bleeding money and owes huge debts. Most of the 50 states are also bleeding money and have large debts, including giant gaps in unfunded pension liabilities. They are perhaps worse off, because unlike the US government, the states cannot print their own money. Then there is the EU. And Japan. There are only a few ways to cure such ills, and none are painless. One thing is for sure: These ills can't go on forever. In the context of all this, fear looks cheap. Conveniently, Wall Street has made fear a tradable commodity. One way to play it is through the iPath S&P 500 VIX Short-Term Futures fund. Though a mouthful, it simply aims to mimic the VIX. It trades under the ticker VXX, and started trading only this year. It's done horribly, as you would expect given the fall in the VIX. Yet it could be a nice play should we have another spike in the VIX. If fear should rear its head again, as it undoubtedly will, the VXX ought to prove nice insurance. More than just insurance, it could return three or four times your money, depending on the spike. Fear is cheap. Buy some before the price goes up. Chris Mayer for The Daily Reckoning Chris Mayer's Special Situations Research Presents... "The Biggest Resource Breakthrough Since the 'Beaumont Miracle' of 1901" 64 publicly traded companies are already deeply invested... insiders are already raking in as much as $205,421 per day on the shares... But only one of these cutting-edge companies offers you the "secret wealth advantage" I reveal in this report... Bill Bonner Capitalists Repeating Communist Mistakes Bill Bonner Reckoning from Baltimore, Maryland... "Panel will tackle national debt," says a headline in this week's Washington Post. Would anyone like to bet? Who writes these headlines? What are they thinking? Are they thinking at all? While the bi-partisan group of bumblers may do something; tackling the national debt - or even slowing it down - is not one of them. It would be going against the tide of modern financial history, which rolls debt into bigger and bigger piles and turns small problems into huge ones. Let us look back. What has been the major trend of the entire past 50 or so years? Government has played a larger and larger role in the US and most western democracies. Only in the formerly (and for many, still) communist countries has government been rolled back. The communists learned their lessons. They proved that government spending does not make people rich. But now...what's this...? The US and other countries are greatly increasing the percentage of GDP spent by the government. The communists proved that central planning didn't work. But again, the US and others are now planning their economies more than ever - managing interest rates, directing capital to one industry while denying it to others, raising taxes on this...subsidizing that...regulating everything that moves... The communists also proved that state ownership of industry was a bad idea. But the US and others now own banks, insurance companies, almost the entire mortgage business, and one of the world's largest automakers. Perhaps most importantly, almost all the 'old' democracies - notably the US - are taking on much more debt. Bankers do stupid things - the feds take over the debt. Homeowners do stupid things - the feds give them more low-cost credit. Politicians do stupid things - and the feds run up even more debt. And it's killing them. They can't raise enough money through taxation to fund their spending plans, so they have to borrow. And borrowing exposes them to big risks. In a few days, America's first time house buyers' tax credit program expires. It's been a great success, say supporters. Let's see, how did it work? According to the news reports, the government gave away $12.6 billion in tax credits. Of course, some people would have bought a house anyway...and could have afforded one without the tax credit. Wait...that means that the only additional sales came from people who 1) didn't really want to buy a house or 2) couldn't really afford one. According to economists' estimates, each one of these people cost the feds $30,000 worth of tax credits. And according to the results of an audit, $139 million was paid out to people who hadn't bought a house at all. And one of the people who got the credit was only 4 years old. A perfect federal program - it accomplished nothing at great expense... And it adds to the debt! Yesterday, the Dow sold off 213 points. Gold rose $8. In the aftermarket it soared even more. What's bugging the markets? Debt. Specifically, the debts of Greece...and Portugal...and Spain... Last Thursday was "Black Thursday" for Greece. News reports told the world that Greece's budget problems were bigger than people had thought. Traders dumped Greek bonds. Greece's debt is now 'junk'...the rating agencies say that if the country is forced to reschedule creditors could get back only 30% of their money. Naturally, lenders are nervous. And investors fear that Greece's problems are not limited to the Hellenes. Sovereign debt problems are as 'contagious' as HIV. All it takes is a little hanky panky of the wrong sort...and you've got it! Greece's budget deficit is 8.7% of GDP. Portugal's deficit is the same. Spain's is higher - at 10.4%. Where's the US deficit? Last time we looked it was projected to be as high as 12% of GDP. By many measures, the US is actually in WORSE shape than Greece. And the rating agencies have already warned about a possible downgrade of US debt too. And by all measures, the US has the biggest pile of debt in the world... Just wait until the sparks hit it. You'll see the world's biggest blow-up! And more thoughts... "Ask me how insurance works." "All right, how does insurance work?" "Well, okay, you give me your money..." "Is that all there is to it?" "Yes." "Is that a joke?" "Not exactly..." Fire insurance works by sharing out the risk of a fire among hundreds of homeowners. In effect, if one house burns down, the others have already put aside enough money to rebuild it. It's a kind of voluntary socialism...freely collectivizing the risk of a house fire. But just because you have fire insurance doesn't mean you will leave a can of gasoline on the kitchen stove. You know it would be a big pain to replace the house and its contents - even if you were made whole financially. That's why it works, because it doesn't change human behavior. So, actuaries can calculate the odds of a fire fairly accurately. But suppose you could insure against losses in the stock market? Or suppose you were guaranteed health care...or a comfortable retirement...no matter what you did? Wouldn't you at least be tempted to live a little? To take chances? To spend a bit more? And wouldn't the whole economy change as a result? For the last 50 years - or more - we have been taking part in a vast experiment. What will happen as more and more risks and costs are socialized? We already saw what happened in the mortgage market. Bankers used to take their risks one by one... If they thought a man was a good credit risk, they lent him money. Sometimes they were right. Sometimes they were wrong. Being wrong from time to time was just a cost of doing business. But then the financial industry collectivized the risk. The banker lent, earned a fee, and then sold the mortgage on to Wall Street, where it was securitized, packaged and resold. What was the consequence? Well, mortgage lenders stopped worrying about individual risks. They changed their behavior and stopped using their own judgment. All they wanted was to close the folder, collect their fees, and move the paper on. Soon, they were lending without asking questions - using low-doc, IO mortgages. House buyers changed their behavior too. Easy mortgage credit pushed up demand...which pushed up prices. Pretty soon, the whole town was on fire. But then the feds stepped in and collectivize the risk even further. Now, Fannie Mae and Freddie Mac are arms of the US Federal Government. And now we're all partners in the insurance company! Now, when houses burn down WE ALL have to pay. We've seen what happened when government collectivized other parts of the financial system too. You can collect Social Security whether you saved for your retirement or not. And you could get unemployment compensation whether you saved for a rainy day or not. And you can get food stamps whether you tried to find a job or not. And now, if you're a major Wall Street bank, you can get a bailout from Washington whether you deserve it or not. How about that? The feds have spread the risk around so much that everybody pays for everybody else's mistakes. Is that a good system, or what? Government insures everybody against everything. Only the government doesn't have any more money... ..So, then you give your money to government... ..and that's all there is to it. 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