Sand Spring Advisors LLC

Changing Volatility Regimes

by,

Barclay T. Leib

September 22, 2007

Volatility is a funny thing. Sometimes I think of it as an oversized balloon stuffed into a

four sided box with open sides on each side of the box, and an air pump slowly inflating the
balloon’s size. Imagine the balloon being pushed around by economic policy makers such that
upon occasion the balloon sticks out of one side of the box as an indication of undue equity
volatility; imagine the balloon popping out of another side of the box representing excessive
volatility in fixed income markets; imagine transgressions by the balloon outside yet another side
of the box representing commodity volatility; and the balloon making it outside the fourth side of
the box representing currency volatility.

It is a Sand Spring hypothesis that in the naturally unstable global macro world that has
evolved since the early 1980s, volatility is naturally popping out at least one side of the box
almost all of the time, but seldom all four sides at the same time. Regulators regularly react to
excessive volatility in one market by pushing against that volatility trend with policy movements;
but no sooner have they calmed down one sector, but another sector revolts. The volatility --
driven by underlying structural economic imbalances left unsolved by simplistic quick fixes --
must express itself somewhere, so the balloon pops out another side of the box so to speak.

Think back to 1985. The U.S. trade deficit was deemed unsustainably large by then U.S.
Treasury Secretary James Baker. But a good politician like Baker (trained at Princeton’s
Woodrow Wilson School -- my alma mater as well) could certainly fix that – just lower the U.S.
dollar to make the U.S. more competitive selling goods abroad! But when the post-Plaza Accord
U.S. dollar policy did not work across 1985-1987 to improve the U.S. trade balance situation,
Baker came up with a new idea. He started to put heavy pressure on the Japanese to lower their
interest rates and stimulate their economy so as to increase demand for American goods. This
was a nice well-intended idea – but unfortunately something else happened instead (the volatility
balloon popping out in an unforeseen way): courtesy of soon lowered interest rates, a property
and equity bubble formed in Japan into 1987-1989 which eventually burst.

And since Japan at that time was the holder of some 25% of global savings -- much of
which was suddenly tied up in distressed domestic Japanese assets -- the global economic world
has never quite been the same. There has been a constant struggle since the Japanese implosion
to deny the existence of a problem -- to restructure and rejigger Japanese balance sheets to try to
sweep the losses taken during its meltdown under the rug. My God, it is 2007, and interest rates
in Japan are still sub-1% in an ongoing effort to recover from this period!

And because interest rates in Japan are 1%, guess where -- on the margin -- global
savings from Japan have headed? The low interest rates in Japan have driven savings into higher
yielding countries like Australia, New Zealand, Europe, and the U.S. The money has poured into
Greenwich CT-based hedge funds, and U.S. mutual funds, and U.S. Treasuries -- and in some
cases, into investments like mortgage- and asset-backed bonds where Japanese (and other foreign
investors with huge dollar reserves) likely have no real place being. A balloon of natural
volatility has been shoved around within its box, but it keeps poking its head out – unwilling to
simply go away.

Within this analogy, one or two of the four market sectors are almost always volatile, but
the other one or two will often be quiet and temporarily contained and assuaged.

Sometimes we are in a commodity-focused world with the bulk of the volatility popping
out in that sector. Sand Spring would argue that such has been the case for the past several years
as gold, base metals, and crude oil have been moving all over the place. But during this period,
fixed income and currency markets have been relatively dead. No matter how crazy gold and oil
became, FX traders yawned, and currency option premiums melted.

Back in 1992 (and maybe in 1984 as well) it was exactly the opposite – commodity
markets were dead, but FX and fixed income markets were all over the place.

Meanwhile, through most environments, U.S. equities have had an upward bias based on
GDP and earnings growth, and foreign capital investment inflows, but occasionally, these
markets have become the focus of extreme volatility -- particularly when investor sentiment
becomes one-sided. Equity markets have had kind of a start-stop volatility process (technically
called a “jump-diffusion pr ocess” to us old options geeks) where long periods of quiet trading are
punctuated by occasional spasms of acute volatility that then quickly abate once again. 1999-2002
certainly comes to mind as an equity-centric world as people focused first on the advent of new
internet technology, and then later on the corporate frauds of Enron, Worldcom, and Adelphia .

But alas, Greenspan pushed the equity volatility balloon back into its box yet again by
lowering interest rates in the U.S. to 1% Libor levels by May/June 2003, and voila, we have come
full circle – a new property investment bubble arrived not on Japanese shores but this time on
U.S. shores.
 This game of keeping interest rate levels artificially low while investment capital still
dutifully migrates back to the U.S. cannot perpetuate itself forever. Some would argue that
foreigners have no choice but to invest in the U.S. There is no other global capital market as
large and liquid in which to recycle investments, and if the money did not come back here, the
whole international monetary system would fall apart. Yet do the economic imbalances that
began in the early 1980’s eventually have to be paid for, or can time and easy money simply
allow the world to grow its way back to more stable economic health?

In the subjective mind of one old trader (me), let’s trace the overall cycle of relative
sector volatilities in a rough table stretching back to 1982:

Subjective Memory of General Sector Volatility

Equity Vol Fixed Income Currency Commodity : Additive Sectors High

1982 High High High High 4

1983 Low Low High Low 1
1984 Low High High Low 2 opposite of 2007
1985 Low Low High Low 1
1986 Low Low High High 2
1987 High High High High 4
1988 Low Low High Low 1
1989 Low Low High Low 1
1990 High Low High High 3
1991 High Low High High 3
1992 Low High High Low 2 opposite of 2007
1993 Low High Low High 2
1994 High High High Low 3
1995 Low Low Low Low 0
1996 Low Low Low Low 0
1997 High Low Low Low 1
1998 High High High Low 3
1999 High Low Low Low 1
2000 High Low Low Low 1
2001 High High Low Low 2
2002 High High Low Low 2
2003 Low High Low High 1
2004 Low Low Low High 1
2005 Low Low Low High 1
2006 Low Low Low High 1
2007 High Low Low High 2
2008 --??? ?? Higher?? Higher?? ??

Highlighted in yellow stripes are the years where three or four sectors have been
particularly volatile concomitantly (1982, 1987, 1994, and 1998)– a relatively rare event over 23
years of history, and yet an event I believe is truly needed if one is to expect crash-like behavior
in the markets as a whole . Even while 2002 was volatile in equities and fixed income, FX and
currency markets were pretty benign during that period, so we weren’t quite at risk of a real
crash. Commodity markets have subsequently started to misbehave, but thankfully FX and
Treasury markets have remained eerily stable, so 2007 doesn’t look that serious either – at least
not yet.

So fast forward to September 18th when Fed Chairman Ben Bernanke tried to come to
the rescue of the equity and credit markets after their dour July-August period of apoplexy. As
discussed above, excess liquidity in the U.S. and abroad drove the U.S. property bubble of 2003-
2006, so let me get this straight, now we hope to solve this problem by creating more liquidity?

Maybe the rate cut will indeed help these sectors in the short-term, but for my money, I’d
bet that the old “volatility balloon” just comes popping out another side of the box. If Bernanke
is cutting rates into the teeth of still strong capacity utilization growth and commodity-push
inflation, shouldn’t the FX markets and the U.S. Treasury markets be over-ripe to revolt and
become more volatile?
 FX markets have also been so dormant for so long, that a week or two ago I heard that
euro implied volatility levels were offered in the interbank market at 6.5% across the entire curve
out to three-years. Mathematically this implies that the market expects the euro to move no more
than about 58 pips a day on average (6.5% divided by the square root of the 250 trading days in
the year multiplied by the spot rate). I am a buyer of volatility at such levels. Currency markets
are just too naturally leptokurtic (fat-tailed) to have this volatility level be the right price for the
next three years.

The way the currency and bond markets have reacted in recent days to Mr. Bernanke’s
rate cut also makes it feel as if something bigger is starting to brew in these quarters. This has led
me to do more Fibonacci analysis of the dollar and bond market once again. Many subscribers
have asked over time that we comment on the currency markets more, so here goes.

While the dollar is already dirt cheap on a purchasing-power-parity basis globally

(particularly against Europe), and we do not like to play the game of buying over-priced
currencies simply because of their momentum, Sand Spring is currently of the technical opinion
that the Euro is headed over the intermediate term to at least 1.51; the British pound is headed up
to 2.1340; and the Japanese yen on a weekly chart basis still has a clear eventual downside
Fibonacci target near 97 yen (or around 1.03 in IMM futures terms – see second long-term yen
chart below).

Along the way, natural short-term stopping points in the euro will be between 1.4180 and
1.4280; then another line of resistance comes in at 1.4432 followed by 1.4700-1.4800; but at
some point, we should reach an eventual target just above 1.51.
 The U.S. also crossed a sad milestone this past week as it fell below par against the
Canadian dollar, and while we previously would not have expected this move, the new ongoing
CAD chart pattern is now suggestive of some eventual further gains for the Canadian dollar to
around .9300.
 Of course if such dollar declines were to happen in an orderly fashion, the falling dollar
would actually make U.S. stocks just that much cheaper to potential foreign buyers. America
would effectively be on super-sale. Maybe Bernanke’s gambit of letting rates fall and the dollar
fall will succeed, and once more create the “illusion of prosperity” in the U.S. where equity
markets advance, while the dollar decline quietly steals away any real U.S. equity gains for
currency-exposed investors.

The key is to not spook the foreigners, and to hope that they are all patsies enough to
continue to accept mediocre returns from their U.S. investments net of the ongoing dollar
depreciation on those investments.

But telling the difference between when a weak dollar is good for equities and a weak
dollar might be bad for equities likely hinges on yet another market: Treasury bonds. If T-Bonds
start to lose their bid, then the game is no longer working, and it’s time to watch out.

Back in 1987 there was a progression of different markets each getting more volatile and
more stressed before they all eventually led up to the Crash of 1987. Bonds fell first in March
1987 and then kept falling steadily throughout the summer. Metals started to rally next in April
1987 and kept marching higher thereafter, and finally, the dollar started to fall in August 1987.
Not until all three of these markets were in motion did a blithely bullish equity market finally
capitulate.

In 2007, it is possible that the only thing different is the order in which these markets are
incrementally adding stress to the system: commodities are in the lead, the dollar is starting to fall
next, and bonds appear to be the final market not yet causing major problems.

But even then, to get a real crash, I also believe that two other ingredients are needed in
the cocktail – something geophysical (a freak London hurricane, for example, in 1987) and
something geo-political (Reagan was bombing Iranian offshore oil stations over the weekend of
October 18th , 1987). If a crash is brewing, it may easily occur as some combination of a freak
NYC snowstorm (leaving the city in gridlock, and some traders unable to access their offices), a
geo-political event of some sort, a dollar decline, and a bond market revolt – all transpiring at the
same time.

Our next minor PEI cycle date is November 13, 2007 – and I have no idea what it may
hold.

What I do know is that Treasuries look sick at present, and now sport a longer-term
Fibonacci rhythm to eventually reach a yield near 6.5%. This is an even higher target yield than
the 5.80% target that we have suggested in the past -- which actually makes sense given recent
market behavior and Mr. Bernanke’s policy response.
 Worse yet, the JGB market in Japan appears poised to fall from grace as well, with an
initial downside price target near 129.77, and then eventually a 122.79 longer-term target.
Meanwhile on the metals side, gold has a clear upside target forthcoming near $780.70.

And longer-term, here’s what we see possible for crude oil…Mon dieux!
 Such a view of Crude above suggests that fundamentally we should be in the “Hubbert’s
Peak” camp expecting global crude oil production capacity vis a vis demand to be in secular
decline. We did indeed recently hear rumors from one of our energy hedge fund managers that
the “watering out” of Saudi Arabia’s huge Ghawar field has become ever more problematic.
Ghawar produces approximately 6% of the world’s daily crude production, and accounts for
about 30% of Saudi reserves. But to get the oil out of the ground, massive quantities of sea water
must be pumped into the ground. The so-called “water cut” is the percentage of water versus
crude (or natural gas) that immediately is seen pumped back out of the wells. When oil analyst
Matthew Simmons wrote his 2005 book, Twilight in the Desert, the water cut at Ghawar was
around 30%. There are more recent reports that the Ghawar water cut may have risen to over
55%. I am obviously not a geologist, but from what I understand large reserves do remain at
Ghawar, but they are very hard to get to as the remaining reserve is aligned more horizontally
than it is vertically at depth. The easy pickings are mostly gone.

Now look at the chart below. It shows that Saudi production peaked all the way back in
2005. At $82 a barrel today, is there any more real capacity available to be turned on? Or is
Saudi production now in secular decline because Ghawar is finally just becoming too old and
used up?

Source: www.princeton.edu/hubbert/current-events.html

Such questions are best left for others besides myself to answer. But I remain a secular
energy bull with a continued strong interest in seismic and oil service companies. Many of these
companies are located in Norway – where I am actually headed tomorrow to see one hedge fund
manager involved in this space.
 To finish my monthly ramblings, properly viewed, it is clear from the discussion above
that equities should be looked at not only in U.S. dollar terms, but also in foreign currency terms.

Yes, as discussed previously, we currently expect new annual highs in the NASDAQ 100
up near 2090-2140 and some individual tech stocks to come, but such may be harder to
accomplish in euro terms or in yen terms. The S&P in yen terms actually looks pathetically
weak, and already perhaps forming a head & shoulders top formation.
 All in all, this is a “stagflationary” world in the making. The use of the term “stagflation”
simply hasn’t come back into vogue yet. Indeed, most economists would consider the mere
mention of “stagflation” in a 2007 context as somewhat radical. Call us trend setters.

The sad thing is that back in 1987-89 all of this could have been avoided if Baker –
instead of jawboning the Japanese to lower their rates -- had decided instead to take another
“tough love” type of economic path. If Baker had decided to genuinely improve the government
deficit, and improve our trade deficit not by trying to export the solution abroad, but instead by
trying to slow down the U.S. consumer consumption patterns at home, I am of the opinion that
the world would be a more balanced and prosperous place today. More specifically, I am of the
opinion that imposing a 10-20 cent added excise tax on gasoline in the late 1980s would have
been the right thing to do. Ross Perot proposed this in one of his election campaigns, and I am
proud to say that I voted for him. But such a platform was of course political unpalatable to
mainstream America. It was not a path most politicians even had the kahunas to propose. Yes,
the U.S. would have had a sharp recession in the short-term, but I believe that the U.S. would
have been healthier for this recession in the longer-term.

Alas, this is all akin to spilled milk today.

Economic policies need to be set not just to balance domestic growth and inflation, but
with a long-term eye to also maintain a reasonable economic balance sheet and a serviceable level
of indebtedness. The U.S. has miserably failed in this la tter regard. Bernanke is simply the latest
iteration of Washington slip ping down a slope of policy mistakes with unintended consequences
and ever-increasing economic imbalances.

Instead of the volatility balloon being slowly deflated, it has grown in magnitude, and
someday might just pop.
 All contents are Copyright © 2007 by Sand Spring Advisors, LLC, Morristown, NJ

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AN IMPORTANT DISCLOSURE
Sand Spring Advisors provides information and analysis from sources and using methods it believes
reliable, but cannot accept responsibility for any trading losses that may be incurred as a result of our
analysis. Our advice should be deemed our personal opinion and not a recommendation to invest.
Individuals should consult with their broker and personal financial advisors before engaging in any trading
activities, and should always trade at a position size level well within their financial condition. Principals of
Sand Spring Advisors may carry positions in securities or futures discussed, but as a matter of policy we
will always so disclose this fact if it is indeed the case. Sand Spring’s principals currently hold long
positions mostly in certain seismic and oil service stocks fully hedged with a short S&P position.