Volatility Is Back

Trend Macrolytics/Smart Money.com ^ | October 28, 2005 | Don Luskin

[frithguild]

Washington intrigue has sent stocks gyrating again. But the fundamentals remain strong.

The period of extremely low stock-market volatility that I wrote about over the summer seems to be history. Back then stocks, as measured by the CBOE Volatility Index, or VIX, were behaving about as tranquilly as they have at any time since such records started being kept. At the lows in mid-July, there had been only 14 other days in the past two decades when stock-market volatility had been lower. It wasn't a very exciting time for fast-money speculators, perhaps, but it was a wonderful, low-risk environment for long-term investors.

Now it's over. Today the VIX is back up to the general area of historical norms. Yes, it's still on the low end of those norms, but it's far above the blessedly becalmed state of just three months earlier. Suddenly, the stock market is a risky place again. What happened?

The answer isn't Hurricane Katrina; it's politics. Volatility actually declined a bit during the worst-ever hurricane. The actual bottom in volatility was the day after the Bush administration nominated John Roberts to the Supreme Court. And the somewhat higher bottom in early October, which was the launching pad for today's volatility surge, occurred the very day Harriet Miers was nominated.

While Supreme Court justices may seem to be a world away from the economic developments that affect the stock market, the nomination process is central to the politics that shapes economic policy. With the Roberts nomination, politics shifted into high gear and created an important distraction for policy makers. With the Miers nomination, politics went off the road entirely. It was such a misstep that the nomination had to be withdrawn Thursday before the damage got any worse.

The victors of last year's election are now in disarray. Scandals have rocked leadership in the Senate and the House, and now a senior White House official has been indicted in connection with alleged leaks concerning the CIA.

So with all this going on, how can a pro-growth administration get its economic agenda accomplished? Well, at the moment, it seems that it can't.

This week the administration caved in to special interests by rescinding its suspension of the Davis-Bacon Act for Gulf Coast reconstruction. That act requires that federal reconstruction efforts pay union wages to workers, whether or not the workers are union members. Now reconstruction will be more costly than it has to be and fewer workers can be hired — all at a time when people in the Gulf Coast are desperate both for reconstruction and for jobs.

And on Thursday a Senate committee deadlocked on new legislation that would streamline the expansion of the nation's woefully tight oil refining capacity that was made even tighter by the damage done by Katrina. Senator Lincoln Chafee, a Rhode Island Republican, was the swing vote that deadlocked the legislation, explaining his decision by uttering the economic malapropism that "We should be addressing our consumption, not just demand." Uh, Mr. Senator, in case you didn't know, consumption and demand are the same thing.

Making matters worse, Bill Frist, the Senate majority leader from Tennessee, called for investigations into high energy prices. Frist made it sound as though greedy companies — like Exxon Mobil with its record profits announced the same day — were behind a vast conspiracy to keep oil prices high. So now there's a risk of "excess profits taxes." Don't ask how oil companies can be expected to build more refineries to keep gasoline prices low at the same time as the Senate makes it harder for them to build new refineries. When Washington is in chaos, logic goes out the window. I've been saying in this column to sell oil stocks, but this is a terrible way to turn out to be right.

All of that leaves the biggest question of all: What will happen to tax relief scheduled to be voted in over the next few weeks as part of this year's congressional budget reconciliation process? In play is the extension by two years of the 2003 lowering of dividend and capital-gains taxes, the critically important tax cuts for removing disincentives to investment and savings. Also in play is the extension of relief from the alternative minimum tax, or AMT. If not extended, more than five million households will find themselves facing sharply higher income-tax rates next year.

Democrats like extending AMT relief, because it affects mostly liberal-leaning "blue" states with high state and local income taxes. Republicans like extending the dividend and cap-gains cuts because they believe that savings and investment are key to growth. You'd think that would be a perfect situation for a political compromise. A month ago I would've said it's a sure thing. But the scene in Washington is in so much flux right now that nothing is for certain.

One critical political risk was avoided this week when President Bush nominated Ben Bernanke to succeed Alan Greenspan as chairman of the Federal Reserve. I wrote several weeks ago that there was the risk that he might nominate Donald Kohn, a career bureaucrat whose monetary philosophy is virulently anti-growth.

Bush might've picked Kohn for no better reason than because he was a Greenspan favorite. An administration in disarray could always say, "Don't look at me — it was Alan Greenspan's idea." Instead, Bush pursued a different path to political safety in his nomination. Bernanke was the candidate whom the market most expected, ranking first in a recent Wall Street Journal poll of economists. By picking Bernanke, Bush minimized surprise.

Bernanke is a life-long academic, deeply steeped in theories about monetary policy that are, in my judgment, as fundamentally wrong as most of modern economics. From my perspective, that's a real issue — and it will have consequences. But the good news is that, if I read Bernanke correctly, for him these theories are just theories, not eternal truths and not policy dogma.

My interactions with Bernanke lead me to believe he's a thoughtful, skeptical and eclectic man, one who will take both conventional and unconventional theories into account and one will have a healthy respect for the real world. Like Greenspan, for all his faults, Bernanke will probably always be willing to say "this time it's different," which means that policy decisions will be made in light of actual circumstances and not what it says in some textbook.

Bernanke won't make every decision correctly. For example, with inflation currently rising and fears about more of it suddenly on everyone's lips, Bernanke's dovish inflation forecasts of the past year or so don't look very good. But Alan Greenspan didn't get every call right, either.

In an imperfect world, perhaps the best thing about Bernanke is his oft-stated commitment to greater transparency in monetary policy. He has called for the Fed to set explicit inflation targets, so the public can clearly understand what its policy objectives are. And he has long advocated more and clearer communication between policy makers and the markets. If you've spent the past 18 years being mystified by Alan Greenspan's tortured locutions, Bernanke will probably come as a breath of fresh air. You'll know just what he means and where he stands.

All in all, these are somewhat dangerous times, and the stock market is showing the signs of it. I continue to see stocks as deeply undervalued, though. So unless downright catastrophe strikes, it seems to me that there isn't much downside here. About the worst thing that can happen is that the upside will be limited.

And whatever other risks and disappointments might be going on in Washington right now, one major risk has indeed been taken off the table. We now have a new Fed chairman who, though I certainly don't agree with him on many things, is surely a smart, sensible, creative and plain-speaking man.

[Drammach]

Bullish...