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Through the fog of volatility

Reuters, London
For long-term investors, financial volatility is like the weather; the storms are temporary, leaving attractive opportunities when the skies clear.
The recent resurgence of financial uncertainty — seen most clearly in a doubling of the Vix .VK index of Wall St equity volatility in the first three weeks of May alone — plays havoc with short-term trading and for many leveraged hedge funds.
Stoked by euro sovereign debt fears and sabre-rattling from financial regulators, this latest surge in the so-called "feargauge" — akeyproxyforgiobalriskappetiteatlarge — saw emerging market hedge funds indices, for example, drop some 6 percent during May.
But for investors with longer-term horizons and valuation convictions, history suggests this is not the time to head for the bunkers.
Remarkably, data on US money market or cash funds shows that while there was some renewed demand for these safe havens during the past six weeks, net outflows from these boltholes since the start of May was still a hefty $40 billion and the net exit this year in excess of a whopping $350 billion.
"You normally make most of your money when the Vix is high, and not when it's low — which is exactly what we saw in 2009 when the Vix peaked and rolled over," said Guy Monson, Chief Investment Officer at asset manager Sarasin and Partners.
"Instinctively, it should start to whet the strategist's appetite when the Vix starts to rise."
Monson cited research on equity performance at different levels of the Vix that showed over the past 20 years when the index is above 28.5 percent — which has been 17 percent of the time — the underlying S&P 500 equity index has gained an average of 36 percent per annum.
Conversely, when the Vix is at 21.5 percent or below, which is more than half the time, the market has fallen by 4.3 percent per annum.
On Friday, the Vix was still hovering about 30 percent, having peaked at almost 50 percent on May 21 from as low as 16 percent a month earlier.
Of course, to see high volatility as a time to buy now requires a firm belief that underlying fundamental valuations remain sound and that the cause of the volatility is temporary and not structural.
But many analysts feel that volatility spiked this time around in large part because markets are finding it difficult to price the vagaries of political decision making, which are dominating the resolution of the euro crisis and the global regulatory backlash to the credit crunch.
Markets are typically adept at discounting economic and earnings trends but are less confident second-guessing the risk of random political actions like Germany's recent unilateral naked short-selling ban or Australia's mining tax plan.
"Big government is back and the market is having difficulty accurately pricing political risk—it's really not had to do it for 20 years. It's broadly been a Thatcherite, Reaganomic laissez-faire environment for that time, "said Monson.