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3 Reasons to be Optimistic (Incl video)

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There are still some equity bears and others who see recent equity rallies as unsustainable or ill-founded. Some, like John Hussman, seem to have allowed discretionary interpretations of economic data to lead them to wrong conclusions. Others, like ECRI's Lakshman Achuthan, made recession calls in spite of insufficient or even contrary data. In addition to widely followed economic data confirming the recovery (non-farm payrolls, PMI, etc.), markets have also continued to normalize. In previous articles over the last several months, we've shown how index implied volatility, cross-asset correlation, volatility skew, and other metrics provide evidence of normalization. Here are some more reasons to be optimistic.

1. FX volatility is pushing toward new lows - I sat down with Jill recently to talk about the fact that G10 FX implied volatility isn't just back to pre-crisis levels; ex-yen, it's actually pushing toward the low end of the range from the early 2000s. Overall that's a good sign for investors.

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2. Equity implied volatility has more room to fall, too. In a recent market overview, "The Death of Volatility," Colin Bennett and Miguel A. Gil at Santander make the case that there are several structural and cyclical reasons why equity volatility should decline in 2013. Some familiar catalysts include:

- Lower leverage due to regulation and structural changes.

- 'Ice age' of low yields likely to weigh on volatility in 2013.

- Tail risks gone as all sovereigns are on road to reform.

- QE backstop to prevent significant equity declines and increases in volatility

- Market is used to sovereign crisis, needs a new crisis for volatility.

Fig. 1. S&P 500 Kurtosis
Source: Santander


3. Fat tails keep getting slimmer and slimmer. One of the interesting features they note about recent market action is that for stocks, kurtosis (the fourth moment of the distribution) is at levels not seen since Lehman went bankrupt: "This analysis shows that 14% of volatility is due to jumps. As we believe equity markets are becoming less jumpy, this could weigh on future volatility. Kurtosis (4th moment) is a measure of how 'fat' the tails are (a measure of the likelihood of extreme movements). Recently, kurtosis has fallen to lows not seen since the Lehman bankruptcy."

Fat tails and frequent jumps make investors nervous; smoother, steadier markets build confidence. Even if stocks take a pause here or we see a period this year of sideways trading and weaker earnings, as long as the tails of the return distribution remain small, more investors should return to the market.

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