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Ross Aldridge In Las Vegas Nevada Examined The 1st And 2nd Quarter 2014 VIX Fear Factor?

|Includes: C, Goldman Sachs Group Inc. (GS)

Ross Aldridge in Las Vegas Nevada examined the correlation of the VIX in 2011 and 2014.

As our contributor Russel Rhodes disclosed:

Over the past couple of weeks I have been out and about representing CBOE and The Options Institute in diverse places such as Schaumburg, IL, San Jose, New York, and Omaha, NE. On these travels I have often been asked about the persistent low level for VIX despite pockets of weakness in the stock market. Yesterday is a prime example as the S&P 500 sold off over 2% and VIX closed the day under 16.00. My understanding is that it was mentioned on one of the business networks this week that investors have more alternatives to hedge so VIX does not reflect fear as it once did. I could not disagree more with that statement. VIX reflects the lack of fear and is correctly doing so. The chart here shows daily closing prices for VIX and the S&P 500 from the beginning of 2014 through the end of the first quarter in 2014 and is a good illustration of why I believe VIX is properly reflecting the lack of fear.

Note the four places on the chart above where I have highlighted spikes in VIX over the past 15 months. The S&P will have hit a small rough patch and VIX moves up based on concerns that the market drop may turn into a protracted correction or bear market move. Now note what happens after these spikes in VIX, the S&P 500 resumes a move to the upside and VIX returns to lower levels. This pattern continues to repeat itself investors and traders become less fearful of the next drop. The last real volatility event in the US occurred back in August 2011 which seems be quickly becoming a distant memory for many traders.

Part of the argument about VIX not reflecting fear is that there are more alternatives to hedge against a drop in the equity market. This is an argument that I have a tough time with when I consider exactly what VIX represents. VIX is the implied volatility of options based on the S&P 500 or SPX Index options. Average daily volume for SPX option trading in 2013 was about 823,000 contracts which was a 17% increase over 2012 average daily volume. So far in 2014 average daily volume for SPX options is running at about 870,000 contracts. Many listed markets in the US have been experiencing negative or flat volume growth. If there are new hedging alternatives that are impacting the level of VIX this would mean that SPX volume should be shrinking, not growing.

VIX is doing what it has done for over 20 years - it is properly reflecting the lack of concern in the market when the S&P has a day like yesterday. The market has become accustomed to small corrections followed by a new high in the S&P 500 and VIX is quantifying that complacency through being a relatively low levels. When we get the next real volatility event that should quiet the critics that say VIX has undergone some sort of change - fear will return and with it higher levels for VIX.

Any 'flation Will Do

I'm astonished to agree with an entire sentence in a Paul Krugman column,

"[I]f you believe that prices should move in proportion to the monetary base, there's simply no way to rationalize triple-digit money growth associated with 2 percent or less inflation."

I came to the same conclusion recently in thinking about buying Treasuries. Inflation is very tame despite inflationists' anecdotes about various items that have gone up in price.

For example, I figured out today that my Chipotle burrito has gone up 28% since 2002 - an annual increase of 2.1%. The CPI is up just barely more - a little over 30% during the same time period of 12 years. Hardly hyperinflation.

Someone on twitter posted a "Japan: population breakdown - 1880 to 2100":

You can see what I'm talking about with regard to demographics; their CPI stopped increasing when the productive population started falling, at the same time that their central bank began a huge increase of the money supply.

The evidence is now showing in the U.S. and Japan that the price index is not a dependent variable of the quantity of money. However, both experiences are consistent with the price index and the quantity of money both being dependent variables of demographics.

Falling working age population seems to cause desperate but fruitless schemes by central banks.

We may have an answer now to our inflation/deflation question. The underlying trend is deflationary. The central bank can panic everyone into buying inflation "hedges" by doing something crazy, but this is counterproductive.

Most importantly, no amount of central bank jawboning is going to make your boss come into your office and give you a raise. You could just get fired, though, if the central bank makes your company's input costs go up too much due to commodity hoarding.

Whenever people are most in a tizzy about inflation and rising interest rates (during this demographic deflation) you can buy bonds and wait for reversion to the interest rate trend.

In conclusion:

Ross Aldridge in Las Vegas Nevada concludes that a long position in SKF will be the best hedge against the inevitable 10-15 percent correction that is heading to the broad markets before we reach 17,000 on the DOW by the end of 2014.

Disclosure: I am long SKF.