Volatility is a sign of a top. The triple digit up and down moves on the Dow in the last few days should make bullish investors reconsider their view on the market. The 15-month rally has been overdone for quite a long time now and even a small event could do some serious damage to prices.
Investors need to realize that the stock rally has been created on a wave of liquidity even though the mainstream media has continually cited an improving economy and good corporate earnings as the basis for the ongoing rise in stocks. Careful examination of U.S. economic statistics indicates anything but an improving economy. They instead show an economy dependent on government spending, stimulus and easy money. As for good earnings, if you believe them, ask yourself what earnings looked like in Q3 1929, Q3 1987 and Q1 2000. They were great, but that didn't prevent the market from crashing shortly thereafter.
As for small problems, they have a way of getting bigger. The oil spill in Louisiana is not just a major environmental disaster, but could cause significant damage to the U.S. economy as well. The entire global financial system could take a hit because of problems with the PIIGS in Europe. The euro (NYSEARCA:FXE) fell to just above the 130 level this morning and that is an important support level. We will have to see if it holds. The EU has handled the situation ineptly from the beginning and has chosen denial instead of action, and proven failed approaches over innovative thinking. China, the epicenter of global growth, also restricted bank credit yesterday for the third time this year.
There is also no question that the technical picture on the U.S. stock market is deteriorating rapidly. However, this has happened before during the last year and the market managed to miraculously recover. Each time, more liquidity came to its rescue. At some point though there is no longer enough extra liquidity to juice the market. While the U.S. Fed has made it clear that it will be keeping interest rates close to zero for a while longer, it is slowly closing down special support programs created during the Credit Crisis. The U.S. is no longer in control of the world economy nor markets, however. Investors need to pay more attention to what is going on in China. There is a severe risk of inflation there and they will have to do something about it sooner or later. This will not be a plus for world markets when it occurs.
Investors who want to short the markets can use ETFs to do so. To short the Dow, S&P500, Nasdaq 100 and Russell 2000, ProShares ETFs DOG, SH, PSQ and RWM can be used. For aggressive investors who want to take a 200% short position, the ETFs DXD, SDS, QID, and TWM are the respective choices. For super aggressive investors, Direxion offers 300% short BGZ on the Russell 1000 and TZA on the Russell 2000. Alternatively, shorting can be done by going long on the volatility index VIX with ETFs VXX or VXZ.
Disclosure: Long VXX