A healthy dose of fear has re-entered financial markets in the final three months of the year. The Chicago Board Options Exchange VIX, a widely tracked measure of market volatility, rose to a two-month high on Wednesday.
Varying news reports offered threats from the Ebola virus and a stagnating European economy as tangential reasons. Perhaps another point is many investors view the U.S. Federal Reserve’s pending decision to raise interest rates as a rumbling train far off in the distance that they now hear headed their way. Closer to the horizon are headlines that can no longer lean on “Fed easing” to explain away rising asset prices and a rising stock market.
“We are in a new period of volatility and it's been developing for the last two or three months,” David Kotok, chairman and chief investment officer of investment advisory firm Cumberland Advisors told the Global Markets Forum on Wednesday. “When you suppress all interest rates to zero you dampen volatility and you distort asset pricing. Now the outlook for interest rates is changing so we are restoring volatility.”
The changes, he said, are evident in a rising U.S. dollar, falling commodity prices and the spread between the high yield and U.S. bond markets.
“These are examples of how things change when you return to more normal volatility and extract and stop monetary stimulus,” Kotok said.
Now comes a waiting game and a test of investors’ mettle to sift through the weeds as Fed policy moves closer to no longer supporting stock prices. The best stock pickers will resign themselves to flushing out those hit by a stronger dollar, those with exposure to commodities, as one example. The result of a stronger dollar on corporate earnings begin to show when companies report third quarter earnings, but more so in end-of-year earnings, Kotok said.
“We expect some downward guidance from companies that are seriously impacted by changes in the currency markets,” he told the GMF.
Kotok’s Cumberland has positioned itself in large cap stocks, which he says in his new book From Bear to Bull with ETFs investors should seek out during bear markets while investing in small cap stocks in a bull run. The small cap Russell 2000 Index hit a five-month low on Wednesday.
“I am overweight large caps in my managed portfolios right now.” Kotok said. “We are underweight small and midcaps, we have been for awhile. I have no way to know if we are in a corrective phase or if the bull market ended. But it's apparent that we have one of the two underway.”
Among other trades, Kotok looks at the VIX every day as well as the quarterly release of estimates of future interest rates assembled by the members of the Federal Open Market Committee.
“Look at the option markets which show the price of real money bets on the future of interest rates. They tell you every minute of every day what sophisticated investors collectively think an interest rate will be and when it will be there. That is a high frequency indicator that deserves continuous attention.”
Click here for the full transcript from the GMF interview: RTRS_David_Kotok_01102014