We thank readers for their comments on our second-quarter market discussion. We also thank readers for the kind words extended to my colleagues and me at Cumberland Advisors for our recognition as one the Financial Times 300.
Readers asked why we started a cash reserve. We were asked what we are worried about, since volatility as measured by the VIX is so low. What makes us concerned?
We see two things happening in the second half of this year that give us pause. The first started a few weeks ago with some of the political changes that took place in the US. It looks to us as if there was a perceptible market response that coincided with slight alterations in the American political landscape. The alterations seem to suggest that the Republicans will gain strength in the US Senate due to additional weaknesses in the Obama Administration. In addition, Eric Cantor lost his primary. Readers will be aware of the other activities that have led to the prospect of a Republican majority in the Senate. Certainly, if the Republicans remain in the minority, they will be only narrowly so, while the Republican Party in the House of Representatives is set to become even more deeply entrenched.
Why would those developments elicit a market response, and where do we see it? We look at the credit default swap pricing on US credit. It is denominated in the euro and trades on the London Exchange. That pricing has been rising for the last few weeks. That means that global investors are paying a higher price for US credit insurance. This is a market adjustment the rest of the world has made in how they view us.
Why would this adjustment be due to the US political shift? It boils down to this. The US debt limit will likely be in play again next year; and if the Republican Party gains greater traction in Congress, then congressional dysfunctionality may intensify. Astute market observers in the rest of the world, if not in the US, think that prospect means the US needs to pay more for credit default insurance.
Credit default swap pricing on its own does not trigger bear markets on US stock exchanges. The evidence to support that statement is solid. But if a rising American CDS coincides with a rising VIX, the combination is dangerous for US stock investors. We do not know if that is going to happen. We see one variable in that equation – the CDS – in a rising price mode.
The second issue that concerns us in the second half of 2014 has to do with the foreign exchange markets. With all central banks suppressing interest rates to near zero, volatilities have dropped. We have now seen this for several years. The markets have enjoyed the benefits of low volatility, but we are now entering a time when central bank policies are changing. There may be some tightening in the UK. In Japan, we will not be sure of the policy until sometime in the second half of this year. In the US we are tapering towards a neutral position. In the Eurozone there is talk of additional easing but no action. This is one of the reasons the euro remains relatively strong. In any case, the G4’s ultra-low interest rates and the expansive mode of G4 central banks is about to change. Markets know this. They know that volatilities may rise, particularly in the foreign exchange market.
These are the two main factors that have given us pause at the end of the second quarter this year. We think a market correction is possible, and the likelihood of such a correction is rising. Therefore, we are holding a cash reserve. We may put it to work at any time. The strategy may change any day.
Happy 4th!
David R. Kotok, Chairman and Chief Investment Officer