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Why Are the Markets So Volatile?

As you’ve no doubt been following, global markets have been extremely volatile as the world attempts to pull itself out of the Great Recession. Leaders worldwide are pulling every lever possible in an attempt to stabilize their countries’ economies and instill investor confidence. Recently, the Federal Reserve introduced “Operation Twist” to lower long term interest rates by flattening the yield curve in an effort to make home prices more affordable. At the same time, the U.S. government is struggling to cope with a $1 trillion budget deficit. Across the pond, the European Union is debating what to do with Greece and Italy, how to recapitalize Europe’s major banks, and of course maintain the euro. In addition, the growing voices of protesters in major cities, such as those of Occupy Wall Street, are fueling public anger over the widening disparity of wealth. It is no wonder that markets worldwide are directionless and jittery with every new stimulus measure. Governments are scrambling to find the silver bullet to alleviate market jitters, but there is only one thing that will calm investors’ minds: predictability. Investors hate uncertainty, and there has never been a time in recent history when there has been so much uncertainty over the future of taxes, currencies, budgets, and regulation.

One of the most significant unknowns is taxes. The Bush Tax cuts, enacted in 2001 and 2003, are set to expire in 2012, coinciding with what looks-to-be a heated Presidential race centered on tax reform. Momentum is growing on raising taxes; but whether it will be in the form of a tax on the wealthy, a flat tax, or 9-9-9, is anyone’s guess. Unknown future tax rates contribute to volatility because savers evaluate potential investments based on projected future net (after-tax) cash flows. Investors discount future net cash flows using a reasonable cost of capital to determine an estimated current market value for an investment (whether it is a stock, real estate, company, etc.). Very small changes in the after-tax cash flows lead to large fluctuations in the calculated present values. If investors do not know how much they expect to pay in future taxes, the range of discounted present values becomes wide and therefore, meaningless. Given that 2012 is an election year, it is unlikely that any tax changes will be made between now and then. Investors, meanwhile, are left in the dark. This uncertainty explains, in part, why corporations are sitting on large piles of cash, waiting to see how they will be taxed.

Furthermore, no one knows the future of Greece, Italy, and the euro. The Eurozone is tangled in a really difficult conundrum. According to analysts, there is a 98 percent chance that Greece will default on its debt. A Greek default, which has still not been entirely ruled out, would reverberate among the PIGS (Portugal, Italy, Greece, and Spain). The Eurozone’s largest countries, Germany and France, are discussing a bailout fund to purchase the debt of distressed Eurozone countries and/or issue Eurobonds (like U.S. Treasuries). Unlike the Eurozone, the U.S. can tax its citizens and pay interest on its debt. The Eurozone, comprised of 17 countries that share the euro currency, has one monetary policy system, managed by the European Central Bank (ECB), with 17 different fiscal policies. This means that while the ECB sets interest rates for the entire Eurozone, it has no taxing authority, leaving each country responsible for its own budget. This bifurcated structure also explains why the euro will struggle to be a reserve currency (stay tuned for a future article on this topic).

Increased government regulation is all but certain, but the details of those regulations are still being debated. Whether it is a Wall Street transactions tax or the reintroduction of the Glass-Steagall Act (passed during the Depression; it separated traditional banks from investment banks.) The International Monetary Fund (IMF) recently held its annual meetings in Washington D.C. with attendance from heads of major international banks. The most pressing issues on bankers’ minds were not European solvency, future of the euro, or the global recession, but rather, the future of regulation, specifically, the Frank-Dodd act and Basel III capital accords. The Frank-Dodd act is one of the most far-reaching financial regulatory reform measures taken since the Great Depression. Many of its provisions have yet to be finalized, which is why several industries are in limbo. The Basel capital accords are international standards that require banks to hold minimum capital levels commensurate with their risk. Banks are reluctant to make any significant changes or investments until they see the final versions of these two sweeping regulatory measures.

The world, the markets, and investors all over the globe are waiting; they are waiting for their governments to act with clear direction and consistency, instead of temporary band-aids. The most recent debt ceiling debate in the U.S., and the subsequent downgrade by S&P, was an embarrassing black eye for Americans. It demonstrated that Washington is not focused on solving macro economic problems. U.S. companies will not deploy their huge cash reserves into profitable investments, which lead to hiring, until there is relative calm in Washington and a somewhat predictable tax environment. No amount of quantitative easing or temporary tax holidays will incentivize companies to begin hiring or spending their huge cash reserves. Companies are looking for concrete policies from Washington, stable and predictable taxes, consistent and fair regulations, and some form of stability in the Eurozone. We need a long term solution to the debt problem combined with a fair, yet predictable, tax code.

Ara Oghoorian, CFA, CFP® is the president and founder of ACap Asset Management, Inc., a “Fee-Only” financial advisory and investment management firm located in Los Angeles, CA. Contact Ara at aoghoorian@acapam.com or on the web at www.acapam.com for a complimentary consultation.