We're at a pivotal point in the market. There's so much uncertainty coming from various areas of the market. Between Fed Tapering, Syria's conflict and Middle East tensions, and the debt ceiling debate, we have a number of situations that can really send markets lower on a global scale. I am sure we have all noticed volatility picking up in recent times, since all these events seem to be converging on us all at once. But in crisis there's always opportunity!
I recently started looking at the Volatility Index (VIX) (NYSEARCA:VXX) (NYSEARCA:UVXY) as a way to profit from the uncertainty in the market. The volatility index measures the implied volatility of the S&P 500 index options. Some like to call the VIX the fear index or fear gauge, because the higher it goes the more uncertain the psychology of the market is. It is also negatively correlated to the S&P 500. The VIX is looking like a really good trade right now as a way to profit off the uncertainty, hedge your portfolio, or even use as an indicator for where we are in the market.
Since 2008 the Federal Reserve Bank has conducted 3 rounds of quantitative easing, with the latest buying $85 billion dollars a month in bonds. The Fed has been planning on slowly winding down the bond buying program. The Fed has been supporting the economy since 2008 with its bond buying programs and is actually one of the largest buyers in the market. Anytime you have such a large buyer leaving the market there will be negative effects. The Fed has bought trillions of dollars in bonds to support a slowly recovering economy. The Fed has set targets of 2-2.5% for inflation and 5-6% for unemployment before we begin tapering. There's a lot of speculation right now about when it will start and how much they should taper. We should get a definite answer or at least a clearer picture at the next Fed meeting on September 17-18.
Syria has been in a civil war for the past two years. On August 21, 2013, there were reports of a chemical attack on the people of Syria by the Assad regime. Obama was pushing for a military strike against Syria due to the events. There's a lot of speculation on what really happened and who did what. Obama's administration concludes there's solid evidence that there was a chemical attack by the Assad regime on the people of Syria, while Assad claims otherwise. On Tuesday September 10, 2013 Syria agreed to work with Russia to surrender the chemical weapons to the UN for destruction if the US agrees not to take action. Obama decided to delay Congresses vote on taking military action and take the diplomatic approach to solving the issue. Although it seems like a military strike is less likely to happen, there's still a lot of uncertainty surrounding the situation and this has made markets very uneasy over the past few weeks. If you haven't noticed when the headlines seem like we are likely to strike the market has been very bearish on those days, and when it seems as if we will not, the market tends to be bullish on those days.
In 2011 Congress set the amount that the government can borrow at 16.4 trillion. In December 2012 we reached that limit and the Treasury has taken extraordinary measures to keep the government operating. At the beginning of this year the limit was raised to 16.7 trillion to buy some more time before the US defaults on its payments. We were expected to default in July, but the Treasury revised those estimates to sometime after Labor Day. The government must find a solution to the debt ceiling that will allow the government to continue its day to day operations, but at the same time have a plan for debt reduction. Not finding a solution will bring a lot of uncertainty in the markets and could be cataclysmic for the economy in the long term. This is a very serious issue for many Americans, not solving this dilemma will mean many government services/operations will be shutdown and government employees will not be paid. When we did not resolve the matter in 2011 we actually seen our credit rating downgraded by Standard & Poor's. Very scary situation, and I'm surprised this hasn't been talked about more in the media. On August 26, 2013 the Treasury wrote a letter to Congress that if the debt ceiling is not raised, the US will be forced to default on its debt by the end of October. Hopefully negotiations will begin sooner than later.
Below we have a few charts showing the correlation between the S&P (NYSEARCA:SPY) and the VIX. As we can see, the two have developed a pattern of extreme concavity in opposite directions, then cross each other, and begin rounding out in opposite directions all over again. On the chart below we can clearly see some of the major events we experienced over the past few years. We can see the height of the tech bubble before the crash, the market height of the housing bubble before the crash, and Europe's Sovereign debt crisis. When both overlap this has also been the bottom in each of these boom and bust cycles. This is a great example of when the technicals and the story are telling us the exact same thing. With everything going on today from Fed Tapering, Syria, Debt Ceiling Debate, and the S&P being at the highs, maybe we are at the extreme points and the S&P and VIX could be turning over. According to this chart it looks like we have a long way to go before the cycle is complete. If you are not using this as a trade, where you short the market and long the VIX, you can at least use it as an indicator to tell you where we are in the market and where we could be heading.
Below we have a 6 month chart of the VIX dating back to the beginning of the year. Just like the longer term chart above the VIX and S&P 500 create the same pattern on a smaller time frame. Although on this chart, we can see how this pattern can be used more as a leading indicator. First we see the pattern form a month before the Federal Reserve announced details for tapering at its June 19 Fed meeting. Next we see the pattern forming again 3 weeks before the chemical attack in Syria on August 21. Most recently we can see the VIX and S&P are starting to diverge. The most recent volatility has been due to the Syria crisis. With Obama lacking Congressional and international support on a military strike, investors have been less fearful of another war. Those interested in this as a trade, this could be a buying opportunity. The pattern hasn't overlapped yet and we have another Fed meeting coming up on September 17-18 and the debt ceiling debate has yet to begin. Also we don't know what other issues might arise over time.
As a sweetener I want to throw in a long term chart of the S&P just so we can have a good feel about where we have been and where we might be going. From a technical perspective we should be good as long as we stay above 1600 and keep trending higher. If we dip below there and happen to hold or trend lower for a while, be weary.