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S&P 500 and its respective ETF - the SPDR S&P 500 (NYSEARCA:SPY), continue to advance little by little as the market got fueled by the recent FOMC minutes and the expectations of the market participants that a new form of QE is near.

Treasuries are following suit. A Bloomberg article reveals there is a big decrease in volumes traded in treasuries though, as the markets await the speech of FED's Chairman Mr. Bernanke at Jackson Hole on Friday. The volume dropped to about $109B while the average daily volume for 2012 stands at $238B. The remarks made on the FOMC meeting did their part and the yields on 10-y bonds decreased 0.04 percentage points to 1.65% on Monday.

To QE3 or not to QE3?

The big question now is whether Mr. Bernanke would reveal FED's new tools in his speech and announce the start of QE3. The Bloomberg article linked above suggests that there are significant expectations that rather sooner than later the FED would announce the start of a new round of buying bonds in order to generate liquidity. The equity market expectations are not much different. A negative surprise on the expected announcement could cause significant volatility in markets accompanied by downside movements.

This could present a nice opportunity along the short side of the equity market which already seems a bit extended to the upside.

Data from the NYSE website on the trading volumes show that:

"trading volumes in July 2012 were down year-over-year and month-over-month across all primary trading venues."

Although the change in month-over-month data could be attributed somehow to seasonal factors, the year-over-year change shows a significant decrease in trading activity which could have long lasting effects. Still the markets continue to advance. Generally this is a sign of being close to a top.

The CBOE VIX index shows another warning sign. Its price graph shows the participants are complacent with the direction of the market. The index's current value of a bit above $17 is among the lowest ones in a 5 year period and is close to a level around which a significant increase usually has followed. Technically speaking the graph of the VIX shows there are bullish divergences (the red lines) formed between the MACD indicator and the index's price which in general means there is a higher possibility of a further increase in index's value.


(Click to enlarge)

VIX graph, source: cboe.com

Some trading strategies in order to profit from or hedge against a possible decrease in equity markets are presented near the end of the article.

Currently my view is that while the FED's Chairman might hint or reveal some of FED's options at Jackson Hole, the economic situation of the U.S. as well as the current market conditions do not warrant an imminent start of a QE3. Moreover, there is a chance the country would face important political and fiscal events ahead. An eventual turmoil caused by them or a worsening of the European situation would require a fresh ammo from the FED.

During the current week a significant amount of economic data was expected to be released. Some of it we already know while other pieces are still missing. Most of the data released seemed in line with the expectations and revealed a continuously improving situation in the U.S. at the moment. The factor that would flash a warning is the decelerating speed of improvement.

The annualized U.S. GDP grew more than the first estimate (1.5%) to a value of 1.7%. Still it is lower than the Q1 value of 2.00%. As the report states:

"The increase in real GDP in the second quarter primarily reflected positive contributions from personal consumption expenditures /PCE/, exports, nonresidential fixed investment, and residential fixed investment that were partly offset by negative contributions from private inventory investment and from state and local government spending. Imports, which are a subtraction in the calculation of GDP, increased."

The increase in imports could be related to the appreciation of the U.S. dollar which makes goods and services produced abroad to be cheaper than those produced inside the U.S.

On the speed issue the report states that the deceleration was primarily a result of decelerating PCE and fixed investments which were partly offset by increased exports. The increased exports in a period of relatively more expensive U.S. dollar could signal an improved efficiency and productivity of the U.S. companies which serves as a good long term sign.

Another positive signal was the Dallas FED Manufacturing Business Index released on Monday. Its value fell much less than the consensus estimate (-8.0) to -1.6 from a previous reading of -13.2.

The same behavior exhibited the Richmond FED Manufacturing Index which was released on Tuesday. Its current value of -9 is above the consensus estimate of -11 and is better than the previous reading of -17.

Having in mind that the manufacturing activity was cited most often as a deteriorating sector in the different regions during the FOMC minutes, such increases in the above mentioned indices could be a start of a positive development.

Pending home sales (month-over-month) (July) also surpassed the consensus (1.0%) and increased by a value of 2.4% from a previous reading of -1.4%. This is in line with the conclusion of the FED's Beige book released on Wednesday. It stated that the

"economic activity continued to expand gradually in July and early August across most regions and sectors."

Next the report adds that

"real estate markets were generally said to be improving. On the residential side, all 12 Districts cited increases in home sales, home prices, or housing construction."

Those are the positive economic developments released during the week so far.

The negative ones include the unemployment and consumer expenditures.

The Beige book admits the

"employment is holding steady or growing only slightly."

The unemployment continues to be among the biggest problems the U.S. economy faces. This is confirmed by the data on jobless claims released on Thursday. The continuing ones saw almost a similar value (3.316M) as the previous one (3.321M). The consensus estimate was at 3.307M. The initial jobless claims remained unchanged at 374K while the market expected a decline to 370K.

The Thursday data on the core personal consumption expenditures for July showed there is a continuing decline, both on a MoM and YoY basis to values of 0.0% and 1.6%, respectively. Previous readings were 0.2% and 1.8%. If this tendency continues it could put some weight on the annualized Q3 U.S. GDP as personal consumption was among the main factors which contributed to a positive value of Q2 GDP.

Given all the presented data the condition of the U.S. economy currently does not look particularly bad. There are signs of deceleration but I doubt they are enough to currently warrant the significantly strong FED measures the markets hope for, including the announcement of a new form of QE on Friday. A verbal form of support is more likely than real actions.

Some Trading Strategies

If a new QE is not announced at the meeting in Jackson Hole or Mr. Bernanke fails to assure the markets the FED is willing and able to act decisively by increasing the money supply and inject liquidity, or if he presents a more hawkish opinion having in mind the upward price pressure mentioned by some of the responders in the Beige book, this could be a negative surprise to many of the market participants. As such it could increase the market volatility and present some downside pressure on equities and Treasuries.

In order to profit from such deterioration in indices a short position in an ETF like the SPDR S&P 500 fund could be used. This ETF is a widely known one which measures the performance of the large capitalization sector of the U.S. equity market. It has an expense ratio of .09%.

The possible increase in VIX discussed earlier, could be used as a protection against a decrease in the U.S. equity market as the VIX value increases when equities fall. Such a protection could be achieved through a position in S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX). This fund offers exposure to a rolling daily long position in VIX futures contracts and has an expense ratio of .89%.

All those positions should be used with caution and protected by suitable stop loss orders as they carry the event risk of not being any negative surprise of the meeting.

Source: Shorting The S&P 500 On Jackson Hole