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Markets and Wind Strength

Summary

For months now, the U.S. Federal Reserve has been increasing the money supply at an extraordinary pace to stimulate economic activity. This money has not yet reached the real economy. The stock market, and markets for raw materials such as oil and gold, are where the benefit is being felt. This is all creating a climate of uncertainty and increased volatility.

Volatility is natural market risk. If Francis Beaufort had been an investor, he would have adapted the scale bearing his name to markets1. Since he was a mariner, the uncertainty he had to face continuously was the wind. In 1805, he developed a wind classification scheme based on the damage that could be caused. His scale, with its colourful and lively descriptions (see the note at the end of this item), could replace the VIX, the rather academic indicator that gives us a measurement of stock market risk. The VIX at 10% would indicate a market with no risk of volatility, like Force 1 on the Beaufort scale. The VIX at 80% or higher, as experienced in October and November 2008 (see Graph 1), is the equivalent of Force 12: this puts us in the midst of a financial hurricane. The current VIX level (a little over 20%) is Force 7: a slight danger that can turn threatening. In Graph 1, the VIX is showing a downward trend as these lines are written (July 23). It is as if the worst of the financial hurricane was over.

However, since June 2009, the Dow Jones Industrial Average has been fluctuating over a range of about 1,000 points, leaving open the possibility – after a vigorous surge between March and June – of another storm approaching. Between May and July, the Dow showed a decline shaped in a “head and shoulders” configuration (the letters CDR in Graph 2). Some 85% of instances of this type of configuration presage a decline. But, if the price begins rising immediately afterwards instead of falling (as in the other 15%), the downward configuration loses its influence, especially if the price exceeds the top of the “head” on its way up, which is the case at this time. We therefore still have Force 7 winds, leaving some uncertainty: we are avoiding a decline, for the moment, but without knowing what comes next.

There are some troubling facts. Graph 2 illustrates a performance which follows that of the money supply created by the Federal Reserve, shown in Graph 3. There was a historic rise in money creation between September and December 2008. This enabled the stock market to avoid total collapse at that time under the weight of problems in the financial sector. However, from January to March 2009 (from A to B in Graph 3), the Fed reduced the money supply and the Dow (A and B in Graph 2) went into a tailspin. From March to May, the Fed again increased the money supply (B, C and D in Graph 3), and the Dow made a spectacular upward leap (B, C and D in Graph 2). Starting in May, the money supply declined once again (D and E in Graph 3), and the Dow also headed down (D and E in Graph 2). As these lines are written, the money supply is rising again, and the Dow is following. It is almost as if there were only one player on the stock market.

The Dow moves up strongly when the companies forming the index turn profits. But the U.S. economy, with a 9.5% unemployment rate, is still far from being a picture of health. A plausible hypothesis for the increases is that money creation, in all its great abundance, has not yet reached the economy to stimulate it and has somehow been turning toward the stock market, where it is pumping up prices, and also toward raw materials. Graph 4 shows that the price of a barrel of oil has more than doubled since January 2009 and that gold has gone up considerably. This is an abnormal performance under current economic conditions. It serves instead as a reminder of the sharp rises in raw material prices (and real estate) during the period when the Fed kept interest rates very low (though today they are even lower), thereby feeding an artificial price rise. The wind is still cause for concern.

Graph 1 – The VIX, the indicator of market uncertainty, also known as the “fear index,” since 2004.
Graph 2 – The Dow Jones Industrial Average since August 2008.
Graph 3 – Money supply in theUnited States since May 2008.
Graph 4 – Oil price on the NYMEX commodities market.
Graph 5 – Gold price on the NYMEX commodities market.
  1. The Beaufort scale of wind effects on land. By consulting an encyclopedia, readers can also find the effects at sea. http://en.wikipedia.org/wiki/Beaufort_scale

The author

Charles K. Langford

Charles K. Langford

PhD, Fellow CSI

Charles K. Langford is President of Charles K. Langford, Inc, Portfolio Managers. He teaches portfolio management at School of Management (École des Sciences de la Gestion), University of Québec (Montréal). He is the author of 14 books on portfolio management, derivatives strategies and technical analysis.

Until 2007 he has been vice-president overlay risk management for Visconti Venosta Teaspoon Approach Management, Ltd. Until 1990 he was portfolio manager for Refco Futures (Canada) Ltd.

He has received a Bachelor degree from Université de Montréal, a Master degree and the PhD from McGill University (Montreal); he is Fellow of CSI (Canadian Securities Institute).