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VOL. 39 | NO. 22 | Friday, May 29, 2015

Economic factors merit concern. But don’t worry

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There are factors conspiring in the market’s industrial kitchen right now that might lead to a fit of indigestion for investors. This week, we will look at the three main ingredients and discuss how to medicate.

Ingredient 1: Complacent Markets

Traders use the VIX volatility index, which measures option premiums, as the emotional barometer of the marketplace. On average, the VIX averages about 20. In the teeth of the crisis, it hit 90.

Today, the VIX hovers near 12, a level it has fallen below in only 8 percent of days going back to 1990. This indicates that markets have become complacent, comforted by accommodative policy makers worldwide.

Global central banks now own over $20 trillion in financial assets, most of which they purchased with printed money, suggesting that the globe is “awash” in liquidity. Not so fast.

Ingredient 2: Illiquid Markets

Ever since the financial crisis, banking regulators worldwide have forced banks to “de-risk.” Trading departments have closed, and proprietary asset inventories have been divested.

This means that banks no longer act as market makers of size, meaning there are fewer on demand buyers of assets.

Since market liquidity is defined as “the degree to which an asset can be bought or sold in a market without affecting the asset’s price,” less liquidity means more exaggerated price movements in times of stress. Rapidly falling prices may lead to rapidly falling prices.

Ingredient 3: Data Dependency

While the U.S. Fed may be “data dependent,” it does not operate in real time.

The FOMC meets only eight times a year, and rate change press conferences occur only four times a year.

Therefore, Fed action can significantly lag “the data.”

By announcing its “data dependency,” the Fed has instructed the market to closely scrutinize every data release, thereby amplifying the market response.

Now Shake Vigorously

The mixture of complacent yet illiquid markets, with data dependency, sets the stage for an unhappy gastric surprise.

Should the markets receive a hot economic number, like a higher-than-expected inflation report, they will quickly react, anticipating Fed reaction at a later date. Due to the complacency and illiquidity, the reaction will likely lead to price overreaction as sellers search for buyers.

Turmoil in interest rate markets brought on by Fed fears will quickly ripple through to the equity markets, and with the S&P 500 only up 4 percent year to date, this record-setting market could quickly turn negative.

However, the market’s overreaction to hot data will eventually lead to an under-reaction from the Fed. The Fed needs rising asset prices to fulfill growth objectives.

Bottom Line

Investor complacency mixed with market illiquidity and data dependency means an outlier economic report could quickly create an outlier market event.

Fortunately, the global economic backdrop looks sound, providing long-term investors with an opportunity to profit from short-term investor pain.

More illiquid markets imply larger price fluctuations, which can be bad … but can be good as well.

David Waddell is president and CEO of Memphis-based Waddell & Associates.

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