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Summary

  • Federal Reserve policy may create a never before seen type of market correction in equities.
  • Any market pullback may be overly orderly without a pronounced risk-off mentality.
  • A market drop in this environment may elevate complacency even more, with very dangerous consequences.

Having been a Chief Options Strategist and Senior Derivatives Trader for over 20 years, this central bank induced complacency has me very confident that the market is going to have a correction soon. The difference this time is that it may be accompanied by much less panic and increased volatility than in past corrections, at least initially. Unlike previous markets that have incubated steep declines that sent investors running for the exits, the current volumes in the equity and options markets are extremely low relative to the magnitude of the market move over the past several years. Interestingly, and most importantly, even with the dramatic rise in asset prices, the current realized volatility in the broader market is as low as we have seen in some time. This can be one contributor to lower volumes, but this time feels different to me. This time, instead of a spike in the VIX and panic rush to the exits, I would argue that enough people are waiting for an anticipated pullback to reenter. The question then becomes, will the world find itself overweight equities into the next market dip?

At this juncture, you might think, "What is the big deal if a healthy, long-awaited correction in equity markets transpires and so-called patient, disciplined and, most importantly, 'well taught' investors use this as a great buying opportunity?" As a stated policy to raise asset prices (specifically equities and home prices) the Federal Reserve in a well meaning effort has been transparent in its intentions to coerce higher levels of consumer confidence and spending, as well as drive corporate chieftains to ramp up expansion and hiring process. It is good for America, so DON'T FIGHT THE FED. We have found ourselves at all time highs and without the ability to get back into the market at any kind of a lower base. Investors have done what they can to avoid fighting the Fed; now, the Fed is changing its tune.

Recently, several public remarks by Fed officials have been strategically disseminated to illustrate their concern for risk taking and complacency indicated by lower volatility in many asset classes.

"One of the things that concern me is there is almost no volatility in markets."

-Dallas Federal Reserve Bank President Richard Fisher on May 19th

The conundrum here is that Fed officials have started to become concerned with market reaction to their stated objectives and have started to fight among themselves, as we see with the internal concern and dissent.

"Masking differing policy views is inconsistent with central bank transparency and duty to the public."

-Kansas City Federal Reserve Bank President Esther George, just last week

How about a new twist on the old adage: "Don't Fight The Fed"…unless of course the market is up 185% from stated policy implementation, and several Fed members openly question the validity and efficacy of their own policies and the level of risk complacency in the current market? I suppose it does not have quite the same ring to it.

So, what would be a welcome, healthy, market correction, or the market pullback that "pauses to refresh" if you will (coincidentally the 1929 Coca-Cola campaign)? Like a cold beverage on a hot day to cool the slightly over heated market down and allow it to continue to all new, better and bigger heights of satisfaction. Well, I am here to tell you the low volumes are emblematic of the fact that a large number of institutional market participants are already in the cold beverage line now waiting for the pullback, hence the low levels of interest and volume numbers currently. This could be a very dangerous prospect.

Given the very low levels of implied volatility, which are driven in large part by the low realized volatility, this should make for an excellent time to hedge equity portfolios and buy volatility. But the Federal Reserve has everyone waiting at the cold beverage counter. This has been a driving factor in what market commentators have called the "vol-pocalypse," referring to the recent dramatic drop in the VIX and realized volatility of the S&P 500, as traders have given up on owning what has been an underperforming asset. So instead of normalcy, we have the opposite and prices for volatility are distorted. I am confident that the argument will not be taken seriously until it is almost too late. Below is a chart showing the VIX cash over the last 12 months and the 100-day Moving Average. (click to enlarge)

The biggest risk is that some central bankers around the world really believe they can get the entire camel through the eye of the needle! This is the most dangerous prospect to an investing environment since the ability to buy equities primarily on margin.

If, and it is a big if, we have this highly thought of 'pause that refreshes' the market in the near term, and there is stability after everyone is served their beverages, and the market is calm, cool and collected, then all can be well. But, what happens if during the next pullback we find that everyone has gone all-in with margin levels again near all time highs, the market becomes completely full of those who were waiting to get in and now there is no more buying power?

Now that traders have capitulated on owning volatility and option prices have collapsed, everyone needs portfolio protection the same way they needed to buy equities in 2009. However, this is where it becomes unique; the most effective protection in this situation may not depend on an increase in volatility levels but, an options posture that will perform within the range of an anticipated market drop that does not require implied volatility to elevate. Having gained historically outsize returns in equities over the last five years, there has never been a more appropriate or opportune time to own this posture for such little cost. It is once we have satisfied this entry level for new investors that we will find out if we are in an overweight situation. Keep a close eye on volatility levels should this transpire, for that could be the greatest indicator of the market's next move.

What does a market look like that has been cooled down by the very same policy makers who overshot their intentions? We may be seeing the beginning of the most anticipated market pullback, and one in which everybody is waiting to jump in. By the time we have seen investors move back into the market, after a calm sell-off, volatility will be paramount again. Maybe the adage should be, "Stay thirsty, my friends."

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Source: Is The Fed Engineering A Market Pullback?