U.S. stock markets suffered another bout with schizophrenia yesterday, losing 18.60 points for a drop of 0.92%, and will likely have another turbulent day today.
Over the past 10 trading days, the S&P 500’s volatility has increased so dramatically that its combined moves up and down total more than 600 points, as graphed below.
This, of course, has sent the VIX Volatility Index gyrating like a seismograph needle. Over the past six weeks, the index which measures the volatility of S&P 500 options has surged three times, two of which have come in the last three weeks since Christmas.
What caused this latest tremor? Should investors sell and jump back in when the dust finally settles? If analysts are right about the kind of year 2015 is expected to be, you may end up waiting an awfully long time for this dust to settle. Investors aught to strap themselves in, because the roller coaster ride has only just begun.
Swiss-Cheesing the Markets
Stock markets around the world were riddled with holes yesterday by an unexpected move out of the heart of Europe in the tiny nation of Switzerland, whose economy makes up just 2.3% the entire European Union’s GDP. The cause? Switzerland’s central bank decided to remove its currency’s peg to the euro.
Since September of 2011, the Swiss National Bank has pegged its currency – the franc – to the euro at a rate of 1.2 francs per 1 euro. Since then, whenever the euro dropped in value, the Swiss bank would spend francs to purchase euros, increasing its euro reserves just enough to restore that 1.2:1 relationship, conversely selling an appropriate amount of euro whenever it rose.
But as of yesterday that peg is no more. From now on, as the euro rolls through its ups and down, the SNB will not be adjusting its franc in lock-step with it, but will allow its currency to fluctuate according to its own supply and demand forces.
And it has lost no time in doing so, as per the graph below. As soon as the SNB made its announcement yesterday, the Swiss franc shot upward in value from 0.8333 euros per 1 franc to in-and-around 1 euro per 1 franc, or par, for an instantaneous appreciation in value of 20% versus the euro, 17.6% versus the U.S. dollar.
Why did the franc move up in value as soon as the peg was removed? Not so much because the Swiss economy is so strong, but more because the European economy is so weak. In fact, this is the reason behind the SNB’s decision to remove the peg in the first place.
Over the past year especially, the Euro’s value has been plunging, dropping from just under $1.40 USD in March of 2014 to $1.16 USD this morning, losing more than 17% of its value in that time. In order to honor its commitment to pegging the franc to the euro, the SNB has had to keep buying euros as the currency sank, continually adding a losing asset to its reserves.
Making matters worse for the Swiss government is the upcoming meeting of the European Central Bank scheduled for the 22nd of this month, in which it is strongly suspected the ECB will implement full blown stimulus measures similar to the United State’s central bank’s Quantitative Easing measures of not long ago. And what could this new stimulus do to the euro except to weaken it all the more, even as America’s and Japan’s stimuli did to their currencies?
Thus, rather than go down with a sinking ship, the SNB decided to cut its ties with the euro, preventing further losses as the euro slides to what many suspect will be a long drop below par with the USD, or another 14% from here.
But why would this news out of Switzerland affect stock markets all the way over in America? We can easily see how a stronger franc would hurt the Swiss stock market, as its exports will now bring-in fewer francs in value, and will thus be less profitable for Swiss-based companies.
But this shouldn’t effect the U.S. very much, should it? Given that trade between the U.S. and Switzerland is really quite low?
Correct; it really shouldn’t effect U.S. companies all that much. Which is why many believe yesterday’s sell-off was over done, and presents a buying opportunity. Yesterday’s sell off had no real fundamental rationale behind it, but was simply the blow-back from the shock to the global financial system caused by the sudden and un-forewarned SNB decision.
Remember that U.S. stock markets have been battling against increasing volatility for several weeks already, increasing the tension with every swing of the pendulum back and forth between sell and buy signals. The sudden jolt upward in the Swiss franc simply added to that tension, and as cowboys out on the range are well aware, it takes just one wolf’s howl to send a nervous herd of cattle stampeding.
“It is adding to this general disquiet in markets that things are volatile and things are changing and central banks are changing,” Wouter Sturkenboom, senior investment strategist at Russell Investments in London informed Market Watch. “I think that’s maybe the underlying cause [for the volatility in U.S. stocks], especially when you’ve had such a good run; valuations in the U.S. are stretched and expensive.”
“This effectively serves as a large VaR [value-at-risk] shock to the market, at a time when investors were already sensitive to poor [profit-and-loss] performance for the year,” George Saravelos, currency strategist at Deutsche Bank, wrote in a note to investors obtained by Market Watch.
Douglas Borthwick, managing director at Chapdelaine Foreign Exchange, indicated that such huge swings in a currency has ended up making some investors who happened to be on the right side of the trade a great deal of money, while causing those on the wrong side to lose a great deal.
“We expect that few risk-management algorithms in G-20 currencies were prepared for greater than 20% moves in a currency pair,” he explained in his note. “Either participants gained or lost considerable amounts.”
Buckle up on the Stock Market Swing
Investors should expect the volatility on U.S. and global markets to continue for a good while to come, as a few more shocks to the system are still on their way.
For one, the ECB policy decision due next Thursday the 22nd should rock the markets again on the announcement of a much anticipated stimulus program. Continuing low oil prices should also keep sending shocks through markets as oil and gas producers begin to lower their earnings estimates and some even close-up shop for a while. Later in the year we have the expectation of a possible interest rate increase by the U.S. central bank which could jolt U.S. markets rather markedly whenever it is announced.
Hence, if increased volatility is here to stay with us for the foreseeable future, we may as well learn to live with it – and learn to trade with it too. How?
By keeping a sizable amount in cash on-hand, ready to be deployed whenever the markets or your favorite stocks drop a few percentage points, perhaps adding a little every 5% down, or even every 2 to 3% down, depending on the amount of cash you have set aside.
Then, on a gain of 10% or so from your last purchase, sell the last amount you bought to lock-in your profit, and get ready to do it all over again when rolling down the next hill.
Just remember that despite the downs being sharper and quicker than the ups, the overall journey forward is leading to the up side, as markets will always carry an upward bias over the longer term.