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When Too Much Hedging is a Bad Thing

The overreaction to the S&P's modest loss last week shows why you should lean against the crowd


It has since taken a while for that subtle, underground erosion to become visible on the surface, but it finally became apparent midweek and again last Friday that the recent advance has rested on shaky underpinnings indeed.

As you can observe in the chart above, and have probably experienced as well, the S&P 500 has dropped 0.75% in the past five days. And, as usual, traders have over-reacted to that relatively modest decline in their typical fashion — by buying much more insurance than they need in the form of options on the benchmark index. This over-buying of protection has shown up as a 7.5% advance in the S&P 500 Volatility Index (VIX). It’s kind of crazy, but we have seen it time and time again: Traders typically obtain about 10 times more protection than they really need.

So now you might wonder why the mood is becoming less ebullient all of a sudden. The fact is that investors’ emotions swing back and forth as the great collective unconscious that comprises opinion swings from optimism that central banks will forget a path out of weak economic conditions to pessimism that the job is hopeless.

It’s natural for investors to want to be optimistic; it’s in our nature. But very often success in the market requires us to trade against our instincts. Everything we do in our normal lives is oriented toward getting along with the crowd — at work, at home, and among our friends. But the market is a completely different beast. You are always most rewarded for going against the crowd: forging an independent viewpoint and adhering to your unique long-term or medium-term insight despite the intense near-term pressures to conform.

At the moment, the strongest forces in the media would have you believe that the U.S. economy is on track for a blistering second half of success, with rising employment complemented with improved productivity and output.

But next week this sunny attitude is likely to run headlong into new data that will likely surprise to the downside. And what a week it is going to be, with the Federal Reserve’s rate-setting committee meeting on Tuesday and Wednesday sandwiched by the release of second-quarter GDP data on Wednesday morning and the release of July employment data on Friday.

We are probably going to learn on Wednesday that second-quarter GDP was at most 1% annualized, which is going to freak people out. But then on Friday will come employment data that will show an increase of around 200,000 non-farm jobs.

It’s going to be hard for even the most sophisticated economists to draw direct lines between all these data points to determine what they mean, and, as a result, volatility will likely increase as bulls and bear slug it out in the court of market opinion.

My reading of the data points suggests that consumption growth has slowed and business investment is also down slightly, and both external trade (things we sell overseas) an inventories (things that are made but not yet sold) will also be slightly lower than anticipated.

This will all be complicated by the fact that next week’s data totaling up the nation’s accounts will incorporate comprehensive revisions to historical data. The new way of measuring the economy will include a column for research and development spending for the first time, along with other intangibles that are likely to make the U.S. entertainment industry (film, music, television) look a lot more valuable than they were under the prior scheme.

Conspiracy theorists will contend that the new measurements will be designed just to make the economy look better than it really is, which would theoretically make the current administration in the White House look good. But the United States is, in fact, only making these changes to comply with the latest global standards adopted by most developed countries. Canada has already published its revisions, and the United Kingdom is on track to do the same next year.

Past years’ data are more likely to be affected than recent years’ data, but these subtleties will give way to snap proclamations in both the bullish and bearish camp that should lead to the kind of uncertainty that fuels volatility.

This is all complicated by the fact that weaker GDP numbers (which will be seen as bad news for Main Street) will make some participants believe that the Federal Reserve is more likely to hold off on its “tapering” of quantitative easing (which will be seen as good news for Wall Street).  Analysts at Capital Economics point out that if second-quarter GDP growth is only 1.0%, then even 2.0% annualized growth in the third quarter and 3.0% growth in the fourth quarter would put the annual growth rate at only 1.6% — which is virtually stall speed for an economy the size of the United States.

And yet — another twist — if there is an upside surprise in the second quarter data, and the historical revisions are also higher than expected, then second-half data estimates will be revised higher. And as a result of this seeming positive news, markets may throw a temper tantrum as expectations for a Fed move to start removing monetary accommodation as soon as September will take hold.

Personally, my own reading of the Federal Reserve is that it is less likely to react to GDP data than it is to unemployment and inflation data. And since job growth has been making fairly steady progress, and inflation remains tame due to the weakness in China and other emerging countries, the Fed will have plenty of cover to start tapering in September as Chairman Ben Bernanke has previously hinted.

Whether you agree with my assessment or not, the bottom line is that next week will provide plenty of reason for stocks to turn down, and volatility to turn up, in ways that will add to the success of the current CounterPoint Options positions.

InvestorPlace advisor Jon Markman operates the investment firm Markman Capital Insight. He also writes a daily swing trading newsletter, Trader’s Advantage, which aims to capture profits of 15% to 40% and often as much as 100% to 200% in less than 90 days. 

Professional traders and hedge funds make huge profits off volatility.  Now, Jon’s service CounterPoint Options levels the playing field with the first service geared towards helping individual traders make steady, consistent profits with the VIX.  Get more information on Trader’s Advantage and CounterPoint Options today.

Follow Jon Markman at Google+.

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