Monday was the quietest session in a month for the stock market with Japanese markets closed and the U.S. bond market closed for the Columbus Day holiday. Barely 800 million shares traded on the NYSE. And for a three-hour period, the S&P 500 was confined to a two-point trading range. As a general rule, low volatility and tight trading ranges are phenomena typically seen at market tops as traders become overconfident and complacent.
Indeed, by one measure (average true range) the market’s daily price movements have dampened back down to levels not seen since the April high. Before that, current levels were seen just before the decline into the February low. But by itself, the ATR indicator isn’t very strong; after all, we saw a steady decline in price volatility during the March 2009 to January 2010 rally.
However, other evidence suggests traders are becoming overly optimistic about the rally in risk assets and the prospect of another round of money printing by the Federal Reserve. And it’s based on the price of portfolio “insurance” provided by S&P 500 options and represented by the CBOE Volatility Index (VIX).
By taking the difference between the near-term VIX and the three-month VIX, we get what’s known as the “volatility term structure” by Wall Street insiders. Don’t let the abstract language intimidate you: This simply measures the difference between near-term optimism and over-the-horizon caution. When this measure drops below 0.8, as it is now, it’s been a powerful signal of an imminent pullback for stocks.
In trading today, this indicator absolutely plunged as if someone hit it over the head with a hammer. The dramatic decline was partially due to technical factors as the VIX rolled out of October options contracts (which are high due to Q3 earnings) and into November contracts. But this doesn’t take away from the fact that investors are unprotected against market declines relative to future volatility expectations on a scale that hasn’t been seen since the bear market of 2007 got started.
And that suggests the potential for trouble in the days ahead as the market gods punish the imprudent for their hubris. If you’re looking for protection, you can get exposure to a rise in the VIX through the iPath VIX Short-Term ETN (NYSE: VXX).
Disclosure: The author does not own or control a position in any company mentioned.
Be sure to check out Anthony’s new investment advisory service, the Edge. He can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.
12 Little-Known Stocks That Will Lead the Mobile Internet Revolution. All my research and proprietary stock picking tools are ringing loud and true right now — mobile Internet is one of the biggest money-making opportunities out there. And these stocks are about to take the Street by storm. Get their names here.
