Complacency has set in during the dog days of August, but there is a catalyst in the very near future that could help stir up volatility.
The European Central Bank is schedule to meet Sept. 4 to discuss monetary policy. The calm, cool way the U.S equity market is trading, it feels like an announcement of a full-scale bond purchase program is baked in the cake.
So if you want to take advantage of low volatility, the market is giving you another chance.
ECB Could Shake Things Up
Market sentiment is high, and there seems to be very little fear that something could go wrong. The CBOE Volatility Index, or VIX, which measures implied volatility of the “at-the-money” strike prices on the S&P 500 Index, is trading near its 52-week lows and reflects very little market trepidation.
However, when the Labor Day holiday closes, investors are expected to return following their summer holidays. Volume in the latter part of August has been unusually low, and an influx of new activity — coupled with the European Central Bank’s meeting next week to determine future monetary policy — could help create a perfect storm to spark the daily volatility of the broader markets.
Market participants were fortunate enough to hear ECB President Mario Draghi speak last week at the Jackson Hole, Wyoming, symposium, and Draghi’s words were carefully spoken.
The upshot was that the ECB believes declining inflation expectations and withering sentiment within the European Union will be met with a monetary policy response.
Although many believe the question now seems to be “when” the ECB will announce a quantitative easing program whether than “if,” the ECB has yet to see its most recent policy changes in action. A wait-and-see statement following next week’s meeting might be the impetus that sends stocks into the long-awaited correction.
A story reported by Reuters on Wednesday cited ECB sources saying that the committee likely wouldn’t change direction in policy unless eurozone data from August points toward inflation. This recent statement could be the sticking point the ECB uses to hold off on a new bond purchase program.
Sentiment indices released this week in Germany, France and Italy continued to show accelerating negative sentiment. Future inflation data is expected to confirm declining prices, but Draghi already knows what the market believes. German 10-year interest rates have declined below 1%, which reflects the markets view that the German economy will not be able to produce the ECB’s goal of 2% inflation.
The question is whether Draghi is concerned about disappointing investors. Historically, the ECB has been slow to through the kitchen sink at a problem, which opens the door for further investor disappointment.
The combination of complacent market sentiment and soft economic sentiment seems to have created a market environment that could quickly change if the ECB fails to meet market expectations of a change in policy.
How to Play It
To take advantage of this disappointment, you can do a couple of things.
- Go long exchange-traded funds/notes such as the iPath S&P 500 Short Term Futures ETN (VXX), which provides investors with long exposure to the VIX. In short, if the VIX moves higher, investors can go along for the ride via the VXX. (Note: VXX charges 0.89%, or $89 on every $10,000 invested, in expenses).
- You could also use an option strategy called a straddle on the S&P 500 ETF such as the SPDR S&P 500 ETF (SPY). A straddle is the purchase of a call option and a put option with the same strike price and identical expiration dates. A straddle on the SPY would gain value if the price of the S&P 500 gyrates more than what the market has priced into call and put options.
As of this writing, David Becker did not hold a position in any of the aforementioned securities.