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Potentially the largest imbalance in the market currently is one of perception. The vast majority of investors and traders have been lulled into a complacent state by watching the Volatility Index or VIX decline to near all-time lows, as the S&P 500 has rocketed to all-time highs in a parabolic move.

Clearly, the attempt of the Fed has been to reduce volatility and restore confidence in markets by adding huge amounts of liquidity to the financial system. This started with efforts to quell the financial crisis by flooding the system with liquidity. As years have passed and the "money printing" has increased (currently $85 billion per month), the goal of stabilizing the financial system has morphed into an attempt to add value to the economy--something the Fed is not capable of doing. The Fed can only create the illusion of value--liquidity.

(click to enlarge)

The Adjusted Monetary Base chart below gives a picture of the liquidity that is currently pent up in the financial system.

Graph of St. Louis Adjusted Monetary Base

Volatility is generally considered to be the size of the move in relation to time. Looking from an unbiased point of view, it would seem that either a large move up or down in a short period of time would qualify as volatility. Volatility, as it can be seen in the S&P 500's rocket-like move upward over the last few months and years, fueled by huge amounts of liquidity, qualifies in my view as rather extreme volatility but it is not being perceived as such by most investors, because the market is going up, not down.

When the market turns and has a significant drop, the perception of volatility will likely become much more realistic. However, investors need not wait to see this volatility coming into the market--look no further than a chart of the S&P 500 to see the parabolic move up. This is clearly not a stable market that is devoid of actual volatility, no matter what the VIX says. The VIX will react to the volatility once it is perceived.

It appears to me that this radical move up in stocks, which has been largely fuelled by extreme liquidity, has been in the process of turning from a situation where the added liquidity suppresses volatility, to one where the liquidity actually feeds the volatility. My view, which is highly subjective, is that this line was crossed after the S&P 500 passed the 1100-1200 range on its way up, as measured against fundamentals and the ever swinging pendulum of fear and greed. After that point the Fed's actions have crossed the line from suppressing a crisis to attempting to add value, or so it seems to me.

Given that the market participant's perception has been so biased in the direction of believing that the liquidity is suppressing volatility, it is not hard to see how easily this perception could change with a turn in the markets. Going long the VIX may hold the potential for investors to see significant gains when the markets and perceptions come closer to equilibrium.

There are wide range of ETFs and ETNs that can be used to trade the VIX. Please do thorough research before choosing and entering them as many of them carry significant risks, due to such issues as; roll loss, contango, leverage, etc. Some of these names have been heavily shorted. The (VXX), for example, recently had a short interest of about 79%. Tickers include: CVOL, IVOP, SVXY, TVIX, TVIZ, UVXY, VIIX, VIIZ, VIXM, VIXY, VQT, VXZ, XIV, XVIX, XVZ, XXV, ZIV

Disclaimer: Nothing in this article is to be taken as professional financial advice, nor is it a solicitation to buy or sell any type of securities. All financial decisions are your own, seek professional advice before taking action.

Source: Fed Liquidity Fueling Stock Market Volatility Vs. Suppressing It