A Messy Affair: Pricing Risk For An Uncertain Future

Mr. Market can be an emotional fellow at times, confusing and confounding the casual observer who tries to make sense out of market action that can appear nonsensical at times… right now, for instance. Indeed, the US stock market has been tumbling since its Dec. 5 peak – a slide that’s unfolded amid an impressive run of US economic releases – the best, arguably, in several years. What gives? Judging by Mr. Market’s reaction of late, there’s danger on the horizon for the economy. The hard data, however, suggests otherwise. What the heck’s going on? Is Mr. Market off his meds again? Or is there some logic buried in the current macro-market mashup?

One explanation is that the market is always looking ahead and so the rally in US equities through most of 2014 anticipated the good news in the US macro releases in recent weeks. In particular, three key economic indicators for November delivered uniformly strong results that topped expectations by a wide margin: private-sector payrolls, retail sales, and industrial production. This trio of strength suggests that America’s modest economic recovery may be shifting into a higher gear. One can argue that Mr. Market saw it coming, and acted accordingly.

At the latest market peak (Dec. 5), the S&P 500’s one-year return was a strong 16%, or roughly twice the historical average. Keep in mind that the rise over the past year, punctuated at times with violent corrections, was subject to quite a lot of doubt and criticism. Judging by the latest economic reports, however, it seems as though Mr. Market’s sunny outlook has been validated.

But the market’s relentless focus on the future means that the recent batch of numbers, although impressive, is old news. Mr. Market is clearly anxious about what may be lurking in the new year. As usual, the future’s uncertain and so pricing the mystery of the morrow will likely suffer from a degree of real-time error and misguided speculation in the short term. The truth will out in the end, but the road to clarity, as usual, will be bumpy.

At the moment, it seems that the market’s anticipating a turn for the worse in economic conditions, albeit mostly when looking at the global economy ex-US. Wobbly numbers certainly dominate the news these days for Europe, Japan and China. Europe’s sufferings are, of course, ancient history at this point, although Germany’s stumbles of late suggest that the macro trend may get worse before it gets better in the Eurozone, if only on the margins. Meanwhile, Japan’s efforts to stimulate its long-ailing economy, after a brief period of encouraging results, seems to be reversing course these days. China’s economy is still growing at a rapid clip, at least by Western standards, but several trends are pinching the rate of expansion in the world’s leading emerging market.

The US, by comparison, looks impressive. But Mr. Market is rightly asking: Can America’s resilience endure if the rest of the world is decelerating… or worse? No one really knows the answer to that question, including Mr. Market, although at times like this — particularly after a bull run — the crowd’s inclined to assume the worst. As such, uncertainty has gone up a few notches lately, despite the upbeat US numbers in recent weeks.

One can argue with a modest degree of persuasion that the world economy will muddle on. Interest rates are still low generally and the sharp decline in oil prices may act as a mild stimulant for economic activity in the US and abroad. It’s another story for countries that rely heavily on crude exports, of course, but falling energy costs can be a net plus for everyone else.

The risk for the US seems to be that the implied acceleration in growth never materializes on a sustainable basis if the stumble elsewhere on the planet turns out to be worse than the current numbers imply. But 2015 could just as easily turn out to be moderately surprising on the upside if ongoing central-bank-generated liquidity and cheaper energy juice output and consumption by more than currently assumed.

In any case, figuring out how all this plays out will be hard on a day-to-day basis, which means that Mr. Market’s forward-looking efforts will be tougher than usual. Volatility in the stock market, as a result, has climbed recently (see definitions below).


It may seem odd that US equities are becoming increasingly volatile when America’s macro profile is showing solid improvement. But given the current global climate, discounting risk has become more challenging. In turn, Mr. Market requires a bigger margin of safety in the form of lower prices, which translates into a higher expected return over, say, the next three to five years. It may look like chaos and irrational behavior in the short run (and to some extent it is), but after adjusting our perspective for a longer time horizon there’s a method to Mr. Market’s madness. Yes, finding equilibrium is a rough game when measured in daily or even weekly periods. But deviations from supply/demand equilibrium have been known to dispense opportunity at times.

The percentile rank data is calculated in R with the runPercentRank function. The five measures of S&P 500 volatility cited above are defined as follows:

VIX: market expectation of near term volatility for S&P 500 based on index option prices.
EMA: 30-day exponential moving average of the S&P 500’s squared daily % return.
SD: 30-day standard deviation of the S&P 500’s daily % return
Garch.norm: a Garch(1,1) model that assumes a normal distribution via the rugarch package in R.
Garch.std: a Garch(1,1) model that assumes a “fat-tail” distribution based on a Student’s t-distribution via the rugarch package in R.