In today’s Exponential Investor

  • What’s next? Two scenarios
  • What’s next? What to watch
  • Keeping an eye on volatility

Noise in financial markets this week has emanated mainly from two sources.

The first is the Omicron variant of Covid.

The second is the Federal Reserve (“the Fed” – the central bank of the United States).

What does one make of it all?

Omicron: catalyst for sharply lower – or higher – prices

Both from a personal and a financial perspective, this new variant of Covid has the potential to ruin Christmas.

There is the possibility of no household mixing (once more), as well as a slide in stock prices. 

That’s a bleak scenario, but will it come to pass?

So far, we do not have sufficient hard facts.

Various pharmaceutical CEOs are weighing into discussions, saying that vaccines either will or won’t continue to provide protection against the new strain.

Governments are acting more quickly than in the past regarding closure of borders, and impositions of mask mandates, which suggests they won’t be shy to return to lockdown measures if required.

As investors, there are many scenarios that we could consider. However, there are two main ones:

Scenario 1: Omicron turns out to be serious and many economies are locked down by their governments once more.

This might be bad for markets, but if it leads central banks to refrain from tightening monetary policy (meaning that they refrain from increasing official interest rates and/or reducing purchases of bonds), then perhaps not…

Omicron could be so bad that its impact outweighs effect of such a policy response. For the moment, though, the likelihood of this looks to be small.

Scenario 2: Omicron turns out to be manageable or non-threatening. In this case, it could ignite the final surge in markets – in the context of many stocks already being at extremely high valuations.

Along with other Southbank Investment Research editors, I have written recently about a number of brilliant market analysts who are sounding various kinds of alarm.

If the Omicron variant is a turning point for markets, the next move in share prices could be either up or down.  

And the move could be sharp…

Same chairman, different adjective at the Federal Reserve

In late November, Federal Reserve chairman Jerome Powell was nominated by US President Joe Biden for a second term of office. Powell has been busy ever since.

In his testimony to the US Congress on Tuesday this week, Powell explicitly suggested that it was no longer appropriate to refer to inflation in the United States as “transitory”.

In fact, “sticky” might be more apt as an adjective. Powell noted that:

“Most forecasters, including at the Fed, continue to expect that inflation will move down significantly over the next year as supply and demand imbalances abate. It is difficult to predict the persistence and effects of supply constraints, but it now appears that factors pushing inflation upward will linger well into next year. In addition, with the rapid improvement in the labor market, slack is diminishing, and wages are rising at a brisk pace.”

The market response to all this was ostensibly bleak, with most stock market indices worldwide falling 1.5%-2%.

This reaction follows logic. Not only is inflation more serious than had been thought, but it also increases the likelihood of an accelerated normalisation of monetary policy (accepting that monetary policy is partly to blame for elevated inflation). As noted above in the discussion of the Omicron variant, “normalisation” of monetary policy in this context means higher official interest rates and reduced purchases of government bonds by the central banks.

But within the context of the swings of the recent past , it was not such a dramatic move. The fall last Friday was worse. Global markets bounced on Monday and Wednesday.

Nevertheless, conditions in markets are not nearly as bad as they were in March 2020.

In this context, the key indicator is the VIX index.

Introduced by the Chicago Board Options Exchange (CBOE) in 1993, the VIX index uses the prices of short-dated options on the S&P 500 composite (a very widely used measure of the US stock market) to calculate a measure of volatility in the near-term future – as anticipated by investors.

The higher the VIX, the greater is the volatility that is expected over the next 30 days. With good reason, the VIX is sometimes referred to as “the fear index”.

Having been 15-22 for much of 2021, the VIX is now at about 31 – which is the highest level since February this year.

It peaked at nearly 66 in late March last year.

In the worst-case outcome, Scenario 1 for the Omicron variant of Covid (as outlined above) would be combined with an aggressive tightening of monetary policy by the US Federal Reserve and other central banks.

The central banks’ main focus would be on inflation – with the tacit recognition that it has been boosted by their own policies.

This is at the context of many leading stocks still trading at valuations which, by historic standards, are extraordinarily high. We are still in the midst of a speculative “bubble”.

You can imagine the rest…

However, this is only the worst-case outcome: many others are possible.

As a rule of thumb, though, the greater the time that the VIX is trading at 30 or above, the higher is the likelihood of the worst-case outcome.

If the VIX is moved by outsiders, who are the insiders?

The legions of traders and portfolio investors whose collective decisions drive the VIX are one group of protagonists to follow.

A different group worth following are the people who have a very strong sense of when things are going right or wrong for the economy.

These are company executives. CEOs and CFOs have such clear pictures of their businesses and sectors in real time, that they are often the first to sense when things are taking a turn for the worse (or the better).

By looking at whether they’re buying or selling stock in their own companies, investors can get a really good, early sense of the direction of travel. Historically, this has been a great strategy.

Do you want to know what they’re doing right now?

Then click here…

All the best,

Kit Winder
Co-editor, Exponential Investor