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Volatility in the financial markets will spike before the end of 2013. The confusion within the Fed combined with a seasonal predisposition for increased volatility as the summer vacation comes to an end could mark the catalyst for a turning point in the markets.

Here are three reasons I believe things are about to get bumpy:

1. Volatility can't go much lower

The VIX index (NYSEARCA:VXX) is getting close to historic lows, as evidenced in the chart below. It has been trending lower even though there have been massive amounts of money pumped into the US financial system. Historically, when the VIX index has dropped below 15 (red sections) the S&P 500 tends to fall as well.

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As investors come back from their summer vacations they might begin to realize that the Fed has left the punch bowl at the party for long enough. Looking back over the past 23 years, volatility has increased from July and is historically the highest in October.

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2. Companies are hoarding cash like it's going out of fashion - it has to go somewhere eventually...

Bernanke's monkey keeps grinding and the crowd keeps dancing. The market movements have been justified with reasonable EV/EBITDA valuations, which kept reasonable because companies are presently stock-piling cash. When companies finally see inflation creep into their purchasing decisions, they'll want to get in and beat the price rises. As cash-piles have grown at the expense of investment in plant and equipment, there won't be sufficient capacity in the economy to meet the newly created demand. It's difficult to put an exact date on when the hoarding will stop. However, when it does it has the potential to turn US inflation into a run-away train that will fuel volatility.

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Source: BoAML, FactSet

It's difficult to predict the exact timing of the bubble bursting without a crystal ball. However, Didier Sornette's research into market dynamics suggested that we're getting close to seeing the pop. He discusses his views here, which predicted that there was a 25% chance for a correction before Bernanke came out and dazzled the markets with his intention to keep the money machine cracking.

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3. The Fed is seriously confused

Headlines following the release of the June Fed minutes:

  • SEVERAL on FOMC say QE tapering likely warranted soon
  • MANY on FOMC say labour gains needed before taper
  • HALF of the Fed indicated it would likely be appropriate to end asset purchases late this year
  • A FEW participants indicated that the committee should slow or STOP its purchases at the June meeting

Narayana Kocherlakota said the Fed is responsible for creating the next toxic asset bubble and urged the committee to do more to stimulate the economy. What more can they do at this point?

On the other hand, James Bullard believes the Fed shouldn't pull back on asset purchases until inflation picks up toward the 2 per cent target.

If the Fed doesn't know what it's doing, the financial markets are sure going to have trouble figuring it out.

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What's becoming apparent is that the Fed doesn't have any more tricks up its sleeve. When the show is over and the Fed believe they see enough improvement in the economy, volatility will pick up. The comments above give the impression that the show is drawing to a close and it could be over by the end of the year.

What does it all mean?

The financial makets are due for a correction, which would result in an increase in volatility. I'd recommend selling on market advances to take profits instead of buying into the rally. Alternatively, options or the VXX could be purchased as portfolio insurance against the imminent downturn.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: 3 Reasons We're About To See Volatility Erupt