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All Quiet On The Western Front: The Low-Vol Post-January Rally And Its Consequences

|Includes: SPDR S&P 500 Trust ETF (SPY), VXX, VXZ

I don't have to throw out statistics like the 70%+ gain in the S&P since March 2009 for anyone who follows the market to see that the year-old bull run has been nothing short of spectacular. Unlike some bears out there in the market today, I hold no grudge against the current bull market we find ourselves entrenched within, having traded prudently through it and realizing a good return on my convictions. What disturbs me is the recent, "local" bull market we find ourselves in - namely, the low-quality rally we have encountered since early February of this year.



In my perhaps idealized view, bull markets should be "healthy" - that is, supported to some degree by the underlying economic fundamentals. Of course, the market is cyclical and reflexive and, as many smart people like Soros and Malkiel have pointed out, seldom "right" ex-post despite its amazing efficiency ex-ante. What is a healthy market then? No one expects bull markets to behave with the ferocious relentlessness of bear crashes, so a natural requirement for a legitimate bull market would be a subdued degree of volatility. This signals to us that money is fundamentally flowing into the system, not bleeding out of it (think about how long it takes to blow up a balloon and how quickly it deflates when you let go of the opening at the bottom). Quite obviously in hindsight, we have had exactly that over the past year in the market - a nicely trending market dotted with the expected pullbacks as the bulls climbed over wall after wall of worries ingrained in the apocalyptic predictions of the doomsday theorists.

But that picture has drastically changed. For the latter part of January we have hit a rather prolonged stall in the rise of the market, as soverign debt issues and emerging market tightening began creeping into everyone's bull theses. This, I thought, was expected and welcome: the market has rallied from its lows and is due for a breather before it finds the next set of directions to follow.

The bulls returned triumphantly in February - but something's fishy about the way they ran the Street since then. We have hit a bull market that isn't supported by the type of volume to justify both the magnitude and smoothness of the gains over the past two months. Some technicians fantasize about markets like this with its smooth trendlines and volatility so low that you'd think you are looking at a daily performance chart of Bernie Madoff's fund.



Below I have included a view of the VIX index over the past 20 years. While we can all agree that the Lehman-fueled spike in volatility was an ex-post market anomaly not likely to be repeated in the recent future, I do believe that the speed and sureness with which the VIX has retreated, especially in the past month, is deeply disturbing. Sure, many analysts argue, volatility is reverting to its historical range back in the middle of the 90's where it stayed tamely below 20.

But the important thing to keep in mind, whenever we look at a piece of technical data such as the VIX, is that the numbers need to be viewed with the right pair of glasses on - and in this case, that would be to consider the fundamentals in the market as well as expectations of likely events going down the road. Back in the 90's, the US was enjoying high GDP growth, powered by emerging market developments, low unemployment, falling inflation, technical innovations, entrepreneurship, and relative peace, all of which warranted the tameness of the VIX. But in today's world, things are quite drastically a mirror image of that gilded age: the US economy limps forward on the crutches of the Fed's cornucopia, entreprenurship and small business innovations have shown little signs of growth, terrorism pervades airports, subway stations, and government buildings, and the unemployment rate (despite how they might window-dress it on Friday with Census numbers and such) continues to sap the purchasing power (and purchasing "will", if you will) of the average US consumer. Tag on top of all that the ballooning of debt from historically some of the most credit-worthy nations in the world and you have to ask yourself why, and how possibly, can these landmines not be reflected in the market, both in its price level and implied volatility?



The only logical answer I can find is this: the market is being bid up not by the traditional, long-term investors (keep in mind that mutual funds are only at 3.5% cash levels now) but by the opportunistic, fringe investors, who operate at the border of the "smart money" on the Street. Why would they do something like this? Because they know that most people are NOT sellers right now. Whatever psychological, operational, or plain intellectual barriers there are, most traditional investors are reluctant to take profits off the table at this point, despite valuations popping up each day like weeds in the backyard. Many investors have felt like they are living in Lake Woebegone over the past couple of months, where it seems every piece of economic data coming out is another positive for the market - well, positive enough at least to NOT SELL. Greece's debt is trading at a 3% spread to German bonds despite receiving an IMF pledge? Market moves up. ADP says we are still losing jobs instead of creating them as expected? Market stays put (for most of the day). It seems like nothing in this world can shake the sure-fire march towards Dow 10,000 + 1,000x, x = 1,2,3,...

But we all know how stories like these end. The day the fringe players find a reason to knock down the castle they so meticulously crafted, they will. And when that happens, technicians will freak out about the overdue correction from the double-top or head-and-shoulders they have seen developing but have brushed aside; fundamentalists will freak out about just how high earnings multiples and profit projections have bubbled up towards; and the sell orders will come flying in - with the kind of rapidity and conviction we all remember from not too long ago.

As emerging markets continue to tighten (take a look at what's happening in Australia after its recent series of rate hikes), as more rotten apples fall out of the Euro basket, and as general disillusionment in the market sets in, will you be caught with your pants down? Be wary, my friends.




Disclosure: No positions