When the leaders of the European Union gather in Brussels this Friday for the final EU Summit of the year, they won’t be lacking for attention.
In fact, Wall Street, the European bourses and just about everyone else on the planet with a significant stake in the global economy will be listening in to the conversation, to see if the EU’s key players finally get it right.
Though there are a number of topics on the summit agenda, the one that investors will focus in on with laser intensity will be whether or not the EU can muster the collective political will to propose the tough solutions required to fix the current sovereign debt crisis.
Over the last four months, of course, investors have been riding a wicked whipsaw, as each new round of promises from various euro-zone leaders seems to get countered by the hard opinion of analysts and economists, as well as other EU leaders.
It all has resulted in what is primarily a sideways trend in the equity markets, though one laced with huge dosages of high volatility.
True, the volatility level has certainly dropped quite a bit over the last couple of weeks, courtesy of a concerted effort by six major central banks, led by the Fed and followed by the ECB and four other leading industrial nations. The offer by the central banks proved to be not only a sop to investors craving a quick fix, it also was appreciated by the ECB member states, who jumped on the opportunity to borrow dollars at reduced interest rates, to the tune of over $50 billion for three-month loans. The initial expected response was targeted at $20-40 billion.
Whether this increased demand indicated a greater than anticipated problem, or that the action simply served its purpose to a “t”, is hard to say at this point. Still, as of one week later, Wall Street continues to trend positive, though just barely.
It may be that a return to a more historically “reasonable” level may occur, particularly if the outcome of Friday’s summit serves to allay investor concerns.
But even if it “goes there”, there are multiple reasons to doubt it will stay there for long.
Here, then, are three reasons why high volatility will return in force, and why a “volatility hedge” is a smart play:
1-Internal Forces Factor
The EU is a union, after all, and, as with most unions, things tend to fall apart as the pressure gets ratcheted up. No matter how many times the Merkel & Sarkozy show goes before the cameras professing unity, there are fifteen other players involved in the euro-zone, and ten more in the EU itself, all with their own agendas.
Germany and France are somewhat fundamentally at odds, with Sarkozy hesitant to give up any degree of fiscal independence and Merkel demanding greater shared fiscal responsibility beyond the euro-zone and out to the broader EU. They are also on different ends of the leverage stick, a tool heartily advocated by Tim Geithner to maximize the Financial Stability Facility’s (EFSF) 440 billion euro fund.
Should the two EU powerhouses continue to agree to disagree, no systemic solution will be possible.
2-External Forces Factor
This variant can be, of course, pretty much anything, but most recently embodied by the phenomenally audacious power-grab by Standard and Poor. The ratings agency ended Monday by announcing that the majority of the euro-zone had been unceremoniously placed on “credit watch negative”, indicating that there was an even-money chance that they would all be downgraded a notch within the next 90 days.
A downgrade would result in higher borrowing costs for the fifteen nations, which is hardly what a government wants to hear when it’s already paying nosebleed yields.
Though the market recovered rather nicely from this shock to the system, it serves as a solid example of the type of event that can easily roil investors, and should be expected to occur within the shaky paradigm of the EU’s current crisis structure.
3-The “Let Them Eat Cake” Factor
Probably the most likely reason that the levels of volatility will continue to remain on the high end for the next year or two is that any solution to fix the EU debt crisis will result in circumstances that will maintain low levels of investor confidence.
Any proposal that emerges from the summit, if it is to have any credibility, will be centered on an increase in austerity measures for the euro-zone members, particularly the PIIGS (Portugal, Ireland, Italy, Greece and Spain). The equity markets would almost certainly reward such an announcement with a fast and furious round of buying. It may even turn into a short-term uptrend.
However, any such action would probably require ratification by the EU members, hardly a speedy process or even one with a certain outcome. Once the initial glow fades from the first ecstatic wave, reality will sink in, and with it, uncertainty. As has been seen time and again over the last four months, the first wave of buying is followed closely by a round of selling. And, with the next summit a ways off, the market could experience a fast rise in volatility levels.
The other aspect of the equation is this: Even if the EU proposes a solution, and the solution gets put into affect, the likelihood of increased austerity could sink Europe into another round of recession, which would translate into little, if any, growth.
The citizens of Greece, Italy, Spain and France probably wouldn’t respond enthusiastically to additional belt tightening, and would predictably translate into voting out the current leaders. A new round of politicians would take their place, and you can be certain they will have arrived with an “anti-austerity” slogan on their collective lips.
So, should the above scenario unfold, it couldn’t hurt to have a bit of “volatility hedge” in your portfolio.
One way to use volatility to your advantage is by trading the VIX.
The VIX (Chicago Board Options Exchange Market Volatility Index) widely referred to as the “fear gauge,” stood at 28.6 as of Wednesday’s market close. This places it well towards the low side of its recent four-month trading range, and provides a sweet entry price point.
The VIX reacts sharply and quickly to bad news and uncertainty, which is what makes it so effective as a hedge. Generally, the VIX goes up as the equity market goes down, and vice-versa. This makes it particularly attractive as a short-term hedge against any negative surprise that might emerge from across the Atlantic.
Though you can’t trade the VIX directly, there are a number of ETNs that track the index, with different degrees of correlation.
You can use the iPath S&P 500 VIX Short-Term Futures ETN (VXX) as a way to play the VIX, although it doesn’t mirror it precisely. Like the VIX, VXX usually moves up as the equity market moves down, and goes down as equities tilt up. If you are an options trader, there is a wide range of strikes to choose from.
Another way to play the VIX is with the iPath S&P 500 VIX Mid-Term Futures ETN (VXZ). As it is deals with longer-dated contracts, it contains a lower degree of volatility, and might be more appropriate for buy-an-hold investors, who can add it to their portfolio without too much attention required.
Finally, there is the VelocityShares Daily 2x VIX Short-Term ETN (TVIX), which is a 2X-leveraged ETN. If you want to utilize some leverage, but aren’t an options trader, TVIX would serve the purpose.
Disclaimer: This post is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Daniel Sckolnik and/or Sabrient. Daniel Sckolnik and/or Sabrient makes no representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.