Stocks were clubbed over the head on Tuesday, especially the Dow Jones Industrial Average, ending a period of low-volume, low-volatility tranquility that pushed investors into a dangerous level of complacency.
The result also happened on a Tuesday, which has oddly shown a propensity for market strength. So the day’s losses for the Dow Jones were the worst Tuesday performance in seven months — a gain, a nasty shock for investors used to the pattern we had fallen into.
Click to Enlarge The result was a break of the Dow Jones’ 50-day moving average, a level that has held the index aloft — despite repeated breakdown attempts by the bears — since April.
And more selling looks likely, which is something investors are simply not prepared for.
There were many catalysts for the day’s decline, including a drop in the yen carry trade as Japan’s currency strengthens heading into a Bank of Japan decision tomorrow, eurozone bond market weakness, poor U.S. retail earnings and surprisingly hawkish comments from New York Federal Reserve President William Dudley, who noted that the stock market’s lack of volatility was becoming a concern. (Bubble, anyone?)
Plus, Russian test-fired a nuclear missile for good measure while the geopolitical situation in places like Libya, Ukraine, Thailand and the South China Sea remain in flux.
Despite all this, especially the potential breakdown in the yen carry trade — an extremely popular currency pair trade that has provided rocket fuel to the stock market — investors have been feeling rather indifferent to it all. The Dow Jones has been sliding sideways since the beginning of the year, occasionally slipping but regularly inching higher to new record highs. That has created an environment of predictability and safety.
Ignoring the period of seasonal weakness we’re entering (remember “Sell in May and go away”?), folks have been loading up. Margin debt is at record highs. Sentiment is off the charts.
But what really has caught my eye this week is the performance of the CBOE Volatility Index (VIX), known colloquially as Wall Street’s fear gauge, which has fallen as investors feel less and less need for protection against stock market losses. When it’s high, investors are paying up for portfolio protection. When it’s down, like it is now, it’s a sign they aren’t that worried.
The problem is, they’re feeling so good that it’s become a problem.
Short-term volatility expectations, as measured by the VIX, have compressed relative to medium-term volatility expectations to an extent that’s been seen during recent market tops. We’re at levels that were seen at the tops in January and September, but aren’t quite at levels associated with the November and August tops.
Also, traders have piled into shorts against VIX future contracts, betting that volatility will keep dropping (and thus, the stock market will keep rising) to an extent not seen since the market’s rolling topping pattern last May and again in August.
Finally, the price of VIX option contracts have dropped to a record low. Even Barron’s magazine picked up on the story over the weekend, noting that the volatility implied in the prices of one-month, at-the-money VIX options was among the lowest in history. Lower implied volatility in options contracts pushes down their price.
Jason Goepfert at SentimenTrader only has data going back eight years, but whenever this has happened in the past, the VIX has subsequently moved higher: Of the 45 days when VIX options were as cheap as they are now, the VIX was higher 93% of the time with an average gain of 21%.
Simply put, investors have never felt as good about the market as they did heading into today’s market drop. (At least, as measured by the VIX.)
The same can’t be said for the bond market, where high-yield credit spreads have widened (as high-yield bonds are sold) while 10-year U.S. Treasury bond yields have fallen to test the 2.5% level for the first time since July in a sign of growing doubts over the health of the economy.
A less aggressive play would be the iPath S&P 500 VIX Short-Term Futures ETN (VXX) or simply raising cash in your portfolio. I’ve also recommended VXX call option positions to my clients.
Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he has recommended TVIX and VXX call options to his clients.