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June 3, 2011 6:57 pm

Just because bears are loud doesn’t make them right

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Ever feel you’ve read too much bearish research? It’s a self-inflicted malaise but, let’s be honest, the bears don’t half spin a good story.

First to catch my attention was Paul Marson at Swiss bank Lombard Odier, who predicted a “fiscal adjustment” that would amount to 5.2 per cent of GDP before the
UK is back on the straight and narrow. In the US, he said the corresponding figure was a whopping 7.4 per cent.

He concluded: “Equity markets do not appear to us to factor in sufficient risk premia to reflect draconian policy tightening in the developed economies, let alone potential failures of policy tightening.”

If that wasn’t enough, Albert Edwards at French bank SG suggested that government bond yields would keep on falling even as governments ruined their balance sheets – prompting first a deflationary scare and then double-digit inflation and bond yields.

He also said US economic data suggested we’re one step away from a slowdown in recovery. By the time all this bad stuff has happened, he reckons the S&P 500 will be down to 400. His bearish companion at SG, Dylan Grice, had also screened equity markets and concluded that “almost everything still looks too expensive”.

But the pièce de résistance came from Charles Stanley’s Jeremy Batstone Carr, who suspected that investors had probably missed Belarus’s decision to devalue its local currency by a whopping 56 per cent. I certainly had! Was this a warning of trouble ahead, as governments use currency interventions to ward off inevitable restructurings?

But all these gloomy prognostications don’t seem to fit with what I see on the ground. Business is tough and commodity prices are gyrating up and down, but I still believe the most likely outcome is that we collectively muddle through, without the S&P 500 plummeting or the dollar massacred by currency trader vigilantes.

I’ve been reading this litany of despair for months now and, so far, the best measure of market panic – volatility – has been heading in the opposite direction to that prophesied by the bears.

Take the Vix index of volatility in the S&P 500, for instance. All the smart money seems to have been piling into a massive increase in volatility as markets face up to financial Armageddon. Traders tell me that
long-only bets on volatility have been selling faster than hot dogs at a sausage convention. Yet the Vix remains becalmed.

This inactivity prompts a rather delicious suggestion. If all the smart money says we’re heading to hell in a handcart, maybe the most cunning plan is to bet against this crowd. Maybe adventurous investors should be shorting the Vix – perhaps by using the
US-listed exchange-traded note (ETN) issued by Barclays Capital’s iPath, which inversely tracks the Vix S&P 500 short-term futures index (ticker symbol XXV).

There are two aspects that make this plan cunning – as well as dangerous.

First, because everyone is piling into the Armageddon scenario, the financing cost of keeping open a long position on the Vix has shot up to around 10 per cent of the value of the trade. So, in effect, you’re having to pay 10 per cent a month to carry on rolling over your insurance against Armageddon. However, the other side of this trade – going short on the Vix – is captured by the ETN, so investors in the ETN benefit from the financing cost of the roll-over.

Second, it’s entirely possible that the bears
are right – but markets can ignore the obvious
for longer than many imagine. If so, this ETN should continue to produce decent gains – in the
past six months, it has achieved a 17.39 per cent return.

Inevitably, this will turn nasty when the bears are proved right and short volatility trackers tumble faster than the markets. It may just take longer than anyone thinks.

adventurous@ft.com

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