5 Days of Euphoria Followed by 10 Days of Pessimism

Includes: SPY, VXX, VXZ
by: Stephen Castellano

We do best when we ignore outside and broad investment commentary and instead listen to what our bottom-up model portfolio strategies are "telling" us. This is because general commentary one encounters in the paper or on TV can have a misleading impact on our decision-making as it relates to trading a small basket of "high-quality" stocks, as we define them. This is because not all commentators own our stocks or approach stock picking the way we do.

Whether Saudi Arabia contains revolutionary fervor or not, and what impact it will have on oil prices, is out of our control, but we note that over recent history it has paid more to be optimistic than not. (Our off-the-cuff opinion is that Saudi Arabia has a 4-to-1 chance of containing any short-term disruptive uprising, and there is a 100% chance that over time Saudi Arabia will be forced to gradually become more open.) What is in our control, since we are to a large extent following our theoretical models, is simply whether to rebalance on Friday or the following Monday from nearly 100% cash (since Feb. 15) to 100% stocks.

Most of the time when the VIX surges more than 20% in a single day, our long models follow up the next day with a positive return. Didn't happen this time (on Feb. 22). Looking over our backtests of 6+ years, we see that the recent price action of our model relative to the VIX and S&P 500 is very similar to that of early June of 2010. If we are right, we think we might see about five days of positive returns as the markets euphorically discount the end of Middle East discord, followed by about 10 days of negative returns as euphoria gives way to a more coldly analytical assessment of the long-term implications of the situation.

Recall that in June 2010 there was fear that financial troubles in Europe might spread, the Chinese economy might cool, and there was a lot of uncertainty regarding the unemployment situation and various economic reports and fear that 2010 might be written off as a "lost year" (see this June 29, 2010 New York Times article). Replace fears of spreading sovereign debt defaults and ongoing uncertainty with fears of spreading revolutionary disruption to oil supply lines and ongoing uncertainty, and you have your analogy supporting initial "everything will be okay" euphoria followed by "we will all be riding electric-generating bicycles and eating soylent green" pessimism for March 2011.

We think the euphoria phase might start today.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.