Global Macro Outlook for Volatility in 2010

| About: iPath S&P (VXX)

What should investors make of the exceptionally steep yield curve coupled with the level of stock market volatility, as measured by the VIX index? Back in June, I wrote an article on Seeking Alpha calling for investors to short volatility. Since then the VXX (volatility ETN) has fallen from 75 to 42.5 or by approximately 43%, as the VIX index fell from the 50% range to the low 20% range. Where do I think the VIX is going from here? Applying the same analysis as what I posted back in June would lead to the same conclusions – short volatility represents a compelling opportunity. However, I don’t believe shorting volatility represents quite the same risk/reward as it did before. (Click chart to enlarge.)

In this case, I believe the risk/reward scenario actually points to buying volatility at certain levels. In my opinion the market is inherently unstable. Going into 2010, the global economy/market is being bolstered by massive amounts of government stimulus. In addition to massive government spending, central banks around the world have engaged in outright market intervention by practices such as quantitative easing. Although we can argue about the timing of the exodus of government stimulus, surely we can agree that sometime during the second half of 2010, several governments (if not the majority of governments throughout the world) and central banks will begin withdrawing the stimulus capital as well as slowing down or outright halting intervention in the fixed income markets. At that point we will really see if the global economy can stand on its own two feet.

The temptation to quote a personal hero of mine, Dennis Gartman, is just too overwhelming for me to resist. Dennis Gartman recently said,

Investing is rather like the children’s game of ‘Musical Chairs.’ We must dance while the music is playing, knowing full well that when the music stops we shall all be dashing for the few chairs that are there to be taken and we shall fight for them when that time comes, but while the music plays…while the flute is up to the musician’s lips; while the bow is being pulled across the violin… dance we must, or sit out the game on the sidelines.”

Gartman is really on to something here. In this instance, there is a ton of uncertainty in the marketplace, and quite frankly rightfully so. The more I think about it, the more I think 2010 could be a range bound year for volatility. I can’t really see why the market should average less volatility than the 20-30% range, as seen from 1997-2003, given the vast amount of serious issues, policies, and questions that will remain through 2010. Would I outright short volatility at this level? No. Would I buy volatility instruments such as the VIX between 20-23% or the VIX ETN (Ticker: VXX) between 40-42/per note…absolutely.

I am not outright bearish for 2010, but having said that I also believe whatever 2010 holds in store for investors, it will not be an easy going upward trend for the entire year. When the governments around the world start implementing their withdrawals of support, the markets will be in for a rocky ride. In my mind, the market, expressed in volatility, will resemble the 1997-2003 period in which the VIX was anything but stable – albeit range bound. Thus, until the facts change further, at this point selling volatility at the low 20% level looks like a mugs game. The better strategy, in my opinion, is to buy volatility between 20-22% and sell volatility between 27-32% for the duration of 2010. At some point the music will stop and investors will be rushing for the few remaining chairs…I want to be there waiting to sell them a chair.

Disclosure: Own VXX