Are legendary signals – Copper & VIX – still useful?

What should investors make now of the mixed signals that question the strength of global equity markets? The copper price and implied market volatility strike a strong emotional chord with many investors. There is widespread faith in the power of these indicators to signal danger. How should investors set this emotion alongside the facts of global recovery? Despite the warnings, companies seem to be reporting good results, and central banks say they will persist with stimulation.

Copper’s legendary status as a signal on global growth was underlined in late 2008, when it turned up ahead of stockmarkets after giving a good “sell” signal in 2007. From the 2008 turning point, Copper quickly moved on to a record high in 2011. Investors who paid attention to copper had a good opportunity to get out the market well before lows, and return in time for the new bull market. The indicator has earned its respect. But, now copper is near five year lows. And, the position with iron ore is even worse. This is despite India’s likely boost to infrastructure spend, and continuing growth in China. However, bears have noted that the IMF has just shaded its forecast for global growth; healthy, but decelerating.

Implied market volatility, measured by VIX, is equally concerning to students of history. Often seen as an indicator of complacency – reflecting little disagreement between investors on value or direction – it is now close to long term lows. Normally, more of a coincident indicator, it can move sharply when opinions change. Is its current low level pointing to an unsustainable, rosy consensus?

Confidence in VIX may be misplaced. The indicator largely correlates with trailing volatility, an anchoring effect as investors’ expectations are set by projecting the recent past. Certainly, low volatility by itself encourages leverage and can sow the seeds of future bubbles. But, the growth consensus is an environment created by central banks via money printing and persistent stimulation. Cynics might view this as unlikely to end as long as politicians need to get re-elected, and must deliver economic growth to do that. Investors see little need to insure portfolios while central banks appear to be underwriting markets; not complacency, but realism.

There may also be benign explanations for the metals collapse. Copper and iron ore, along with some other metals, have been used as collateral for loans in China. The pricking of that bubble has played a big role in the current price collapse, as inventory held as security is liquidated. That once looked like a cheap source of finance in Hong Kong, and an easy way to borrow to bet against the US Dollar. As this unwinds, risk in China is falling despite the fear copper’s weakness creates. China is the world’s biggest consumer of copper, but has recognised that speculation has supported the metal price and that overproduction has created a worldwide glut of copper. Bad for suppliers, but it may be good for China and India, and matter little for stockmarket direction.

Behavioural factors impact investors, and one of the hardest biases to overcome is created by conflict between emotion and reasoning; cognitive dissonance. The big indicators have much on their side; social endorsement as “experts” cite them, availability in press headlines, and visual appeal in the form of charts. Images make more impact on us than numbers. Our reasoning is ill equipped to match these forces, or even at times to recognise their hidden appeal. The graphs of the Dow ahead of the Great Crash of 1929 were overlaid with today’s indices in a superficially compelling way, but that says more about psychology than market prospects. That apparent similarity has broken down in recent months.

The failure of some of popular indicators may say more about the unusual times that investors are experiencing. The signals are keeping some money on the sidelines, which is healthy. While that persists, complacency is in check. Investors have to live with contradictory information. Value opportunities are created by doubt and fear: agreement can be dangerous. Signals should not be followed blindly.

A version of this article was published in the Behavioural Finance series in Citywire Wealth Manager on June 26 2014.

Disclosure: The opinions expressed in this article are my own, and may not represent the views of any firm or entity with which I am affiliated. The information presented in this article has been obtained from sources believed to be reliable, however, I make no representation as to their accuracy or completeness and accepts no liability for loss arising from the use of the material. Articles and information do not represent investment advice.

Image credit; http://commons.m.wikimedia.org/wiki/File:Enseigne_Signals.jpg This file is licensed under the Creative Commons Attribution-Share Alike 3.0 Unported license.

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