What Neglected Inflation Means For Stock Volatility

Posted: 03 Mar 2008 | Categories: Investing

These markets are facing volatile times-the Dow traversed more than 100 points in either direction every trading day last week (2/19-2/22). CBOE’s Volatility Index (VIX) is reaching levels not seen since 2003. Any opinion worth two cents offers a reasonable explanation as to why. Even traders with little formal training in finance are now well familiar with arcane areas of structured finance and lenders’ profitable business of pooling, repackaging and selling debt off to Wall Street. I’ll save you the trouble of reading any opinions you find on rate auctions, consumer credit crunch, CDOs, or the newest victim, municipal bond insurance-it’s all bad news, less the occasional proposed bailout plan.

Here’s what you hear less of-where is volatility going? The answer in part leans on a financial storm completely unrelated to the subprime mortgage & bond insurance disasters is brewing. The culprit? Inflation.

Why does inflation affect stock volatility?-after all, we had moderately high inflationary periods during the 90s bull market. Today’s cost-push inflation is different from the demand-pull inflation we had prior to the bubble unwinding after March 2000. Inflation in the 90s had little impact on a firm’s profit margins. Today, with consumers facing low interest rates, holding weak dollars and declining investments, rising prices is bad news profitability.

In high inflationary periods lenders lose and borrowers win. That’s good news for the government and firms issuing corporate debt, but bad news for the pension funds, mutual funds and individual investors holding that debt. Hence, would-be bond investors are keeping cash on the sidelines and looking for excuses to buy into stocks. That’s creating too much money flying in and out of the stock market too quickly and turning prices more volatile. Additionally, Fed Chairman Ben Bernanke in recent months has been forced to aggressively cut rates. So far, the Fed itself admits to tabling inflation concerns and prioritizing on economic stimulant. The resulting excess liquidity will show its ugly face in the form of inflation, and when it hits the system, options holders will be cashing in and shareholders will be looking for something to hang to-tightly.

Look back at the 2/20 trading day. The Fed came out with gloomy economic news, and yet, the market rose about 100 points, simply because everyone figured the news was bad enough to induce yet another rate cut; reason enough for unproductive cash on the sidelines to start working, thereby pushing prices up only to be followed by a massive sell off the next day.

The stock market’s volatility problem arises from an unappealing bond market. When investors become less interested in bonds, stocks usually go up-but only if stocks are quality investments. With all the talk of recession going on, not all investors share the same thinking. The extreme anecdotal evidence of this phenomenon can be seen in India.

India has a liquid stock market with the most active equity changing hands more than 150,000 times on Feb 22 (on the Bombay Stock Exchange, the biggest and most liquid exchange there). The most liquid bond traded once that day. In other words, India does not have a liquid debt market. The absence of a debt market translates into stock volatility since money has nowhere else to go-it’s not uncommon to see index movements in excess of 2% on a given day, and India’s market value dropped by about 10% within minutes on Jan. 22 of this year.

The problem is exacerbated by potential bond market mispricing thanks to old habits. For years Wall Street has focused in on inflation before accounting for food and energy prices (so-called “core inflation”). The argument, ancient as it is, points to the higher volatility associated with food and energy and therefore is a noisy measure of price trend. This thinking prevails today but its merit is completely unwarranted. Consumers, all consumers, are facing higher food and gas prices today precisely because we’re at the doorstep of a major commodities boom. Not everyone buys HD televisions or high-end refrigerators included in the CPI’s durables, but everyone has to buy food, warm their households, and get to work in the morning.

Prior to Jan 2003, core inflation and total CPI had increased 12.7% and 12.2%, respectively, from 1999. Then there’s a kind around 2003, right when commodities really started taking off. Since then, core inflation has risen only 11.1% while total CPI has climbed 16.4%. Clearly, food and energy has been a huge cost-push factor increasing inflationary growth.

Is Wall Street responding? Apparently, no. Although The 10-yr Treasury bond yield has increased in recent weeks due to overall CPI growth outpacing core inflation measures, the yield has largely been driven by the Fed Funds rate since the beginning of the credit crunch. With the Fed themselves admitting ineffectiveness in the cutting, more aggressive cuts can be expected. Excess liquidity and neglected inflation will make bonds less and less attractive, thus causing more money moving in and out of the stock market, hence adding to volatility.

My warning is this: there’s two players to watch in 2008 in order to accurately assess stock volatility-the Fed and bond players (both TIPS-traders and those exposed to inflation). Bernanke is walking a tight rope that may turn out to be a string by the end of the mortgage crisis and there’s two possible outcomes. If inflationary growth continues on its cost-push path and bond traders price this information along with anticipated rate cuts, there may be hope for bonds and shareholders can relax.

The other, what I believe is the more likely outcome brings about higher stock volatility through a combination of aggressive rate cutting and rising inflation attributable to the commodities boom that’s being kept under the radar screens by many bond traders. If you’re heavily exposed to equity prices, you may want to consider using options positions to either lever your bets or hedge out some price risk.

Alan Illing

Article Author :Alan_Illing