Europe Is In The Driver Seat, Expect A Downward Roller Coaster For The Rest Of The Year

Includes: VIXM, VIXX, VIXY
by: Harold Fredrick

Despite a slew of un-noteworthy, tepid economic data, May 2010 was one of the most volatile months of trading in the history of the U.S. stock market. The market thrashed about wildly on divergent daily developments regarding the European debt crisis. And those who played the volatility right made a mint.

Flash forward to today. We find ourselves in a similar situation. Leading indicators are sending mixed signals, and news from Europe is considered decidedly positive one day and decidedly negative the next. The market is responding with extreme volatility. And it will do so until last call for Europe, which will come sooner than later.

My esteemed Seeking Alpha colleague James A. Kostohryz wrote an excellent piece regarding the debt crisis in Europe. According to my friend, Europe will collapse before the New Year. However, the inevitable meltdown will be preceded by a succession of "positive", albeit futile, developments that should provide short-term stimulus to the markets. If James's timeline is correct and the eurozone falls into the abyss by the end of the year, the final month or so left should be better for trading and shorting than May 2010.

Assuming James's prognostication is correct, May 2010 should give us a glimpse of how the rest of the year should play out. During a month of economic data that pointed neither to recovery nor contraction, the Dow swung wildly between 11,152 and 10,137 in May 2010. Incredibly, given the steady stream of lukewarm economic data that was released at the time, the VIX vacillated between 20 and 45. These were unprecedented fluctuations based solely on developments in Europe. Look at the history and see if it doesn't sound familiar:

- May 6, 2010: Flash crash day. Domestic economic reports showed little activity for the week. But there were three key developments from Europe: Federal Reserve Bank of St. Louis President James Bullard made the damning statement that the European crisis would undermine any recovery in the U.S. economy. Moody's Investors Service warned that Portugal's credit rating faced a possible downgrade. And three people were killed in violent anti-austerity protests in Athens. The Dow recovered from the 1,000 point crash by the closing bell but ended the day with one of the greatest losses since the official "end" of the Great Recession.

The Dow fell 348 to close at 10,520. The VIX nearly doubled during the week to close at 41 on the 7th.

- May 10, 2010: Just days after the flash crash, the market roared on nothing but news that the EU agreed on a $1 trillion bailout plan. CNBC buzzed about a bull market in the making. "Nothing can stop this train now," Jim Cramer screamed on "Mad Money". The fear gage fell precipitously to pre-European crisis levels.

The Dow gained 405 to close at 10,785. The VIX fell 30% to 29.

- May 20, 2010: Just a little over a week into the mini-rally, stocks plummeted on news of disagreement as to how to handle the European crisis. Germany demanded for new single currency rules, raising the possibility of the Lisbon Treaty being renegotiated. Germany also shocked the world by announcing to ban naked short-selling. Positive news from the day's Fed meeting did little to repair the damage. The euro plunged to a 4 year low of $1.22 and the market melted down.

The Dow nosedived 376 to close at 10,068. The VIX spiked 30% to a 14 month high of 45.

There were few noteworthy domestic economic developments in May 2010. Nevertheless, the Dow swung wildly and the VIX rose to levels not seen since the depths of the Great Recession. We are now in a very similar period, only amplified. The "recovery" has been in a holding pattern for some time, but daily fluctuations between "positive" and realistic developments regarding Europe's fall into the abyss should provide a framework for short-term investing and shorting. Remember, if James's timeline is correct, the Dow should end decidedly negative at the end of the year.

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