It’s been close to six years since the Federal Reserve began its unprecedented experiment with monetary policy and nearly every asset class is starting to look overvalued. So, how did we get here?

QE

The Federal Reserve was facing the threat of a serious depression so they began a new monetary policy called Quantitative Easing. The easing began in November of 2008, and there was no coincidence that the stock market began to warm up about that time. The Fed has printed roughly 4 trillion dollars since the beginning of quantitative easing. The idea was to bring interest rates down and the Fed did this by actually controlling the markets. They basically took over the Treasury market with its massive purchases and drove rates way down.

The strategy was put in place, in part, to help rescue the real estate markets. Since a large percentage of the economy is driven by the real estate markets something needed to be done to take real estate off of life support. By lowering rates they would be encouraging homeowners to refinance and investors to buy down the large number of foreclosed homes on the market.

The Fed also wanted to support the stock market. When investors were shut out of the Treasury market by the Fed investors turned to the stock market. Corporations started issuing corporate debt at very low rates and forgoing stock issuance. Corporations have been buying back stock rather than issuing stock and Central Banks have been purchasing stocks as well. (Central banks, guardians of the world’s $11 trillion in foreign-exchange reserves, have been buying stocks in record amounts as falling bond yields push even risk adverse investors toward equities.)

The results:

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Economist Anthony Randazzo of the Reason Foundation wrote that Quantitative Easing “is fundamentally a regressive redistribution program that has been boosting wealth for those already engaged in the financial sector or those who already own homes, but passing little along to the rest of the economy. It is a primary driver of income inequality.”

The reason is simple. QE has driven up the prices of assets, especially financial assets. And most of the financial assets in America are owed by the wealthiest 5 percent of Americans. According to Fed data, the top 5 percent own 60 percent of the nation’s individually held financial assets. They own 82 percent of the individually held stocks and more than 90 percent of the individually held bonds.

The actions of the Fed have left few bargains behind. However, there is one asset class that still looks cheap and that is volatility. The volatility index (“VIX”) is an index which measures expectations of volatility, or fluctuations in price, of the S&P 500 index. Higher values for the volatility index indicate that investors expect the value of the S&P 500 to fluctuate wildly in the next 30 days. The index, commonly known by its ticker VIX, is also known as the “fear index” because a high VIX represents uncertainty about future prices.

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The VIX Index just recently hit 10.28 the lowest level since early 2007. Why is volatility so low? Financial market volatility is mostly driven by the credit cycle. When monetary conditions are loose market volatility tends to be lower. Today, short-term interest rates are still stuck at zero, real short-term rates are negative, taking inflation into account. Credit conditions are about as easy as they get.

Are investors getting too complacent? Fed policy has been creating a number of asset bubbles and that is worrisome. Investors also appear to be ignoring rising geopolitical risk, including recent events in Iraq.

The Volatility Index might be a good place for investors looking to protect their portfolios against an unexpected correction.

Another undervalued asset worth looking at is gold. You can read my recent post by clicking here.

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