Don’t Fear the Market’s Lack of Fear

Historically, the Chicago Board Options Exchange SPX Volatility Index (VIX) is a measure of investor anxiety.

Last week, the CBOE Volatility Index reached a 10-year low. The prevailing lack of fear should worry investors, experts say.

There is plenty to worry about. North Korea is testing nukes. The FBI is investigating Trump-Russia ties. And commodity prices, usually a harbinger of economic growth, are plunging. The fact that stocks are tracking to new highs seems counterintuitive.

The S&P 500 is up about 7.2% in 2017, while volatility has fallen some 25%.

However, it’s not wise to be too curious about all of the reasons behind price movements.

This is one of the more important rules I’ve adopted from legendary trader Jesse Livermore. Immortalized in the 1923 classic “Reminiscences of a Stock Operator,” he made a vast fortune identifying and riding powerful trends. He didn’t question them, nor did he stand in their way.

Some say the VIX has outlived its usefulness as a measure of fear. The rise in indexing means investors can easily diversify. There is no need to trade individual stocks.

Others argue it is just about sophistication. Thomas Peterffy, founder and CEO of Interactive Brokers Group, told the Wall Street Journal that he believes income-generating option strategies keep individual stocks and exchange-traded funds range-bound.

“When it starts moving up, there’s more and more selling pressure,” says Peterffy. “As it falls, there’s more and more buying pressure.”

Narrow ranges squash volatility.

This reality is not lost on Wall Street. In 2010, the VelocityShares Daily Inverse VIX Short Term ETN (XIV) was launched. It was designed to rise when volatility declines.

And it has been a very lucrative trade. The Financial Times reports the XIV is up more than 700% since launch, and 22% since mid-April.

XIV has gained more than 68% so far in 2017.

Shorting volatility works because near-term volatility futures are almost always cheaper than their longer-term counterparts. The XIV sells the longer-term contract against the near-term future, which can help you pocket the difference over time.

It’s like selling insurance against extremes, which rarely occur.

Not surprising, because the trade is crowded, it has self-leveling properties. Even big surges in volatility, like the aftermath of Brexit or the U.S. presidential election, were quickly corrected. Strong price gains in volatility bring aggressive selling, and vice versa.

Diving in more specifically, the VIX dropped below 10 for a little while on Monday. That was only the 20th day since 1992 that the index clocked in at a single-digit reading. Bespoke Investment Group notes that low volatility stretches tend to occur in clusters every 10 years or so. The first occurred in 1993, the second from 2005 to 2007 and the third has come this year.

Contrary to conventional wisdom, the historical record shows that these low-volatility streaks do not tend to lead directly to market trouble. The 1993 example occurred ahead of one of the greatest stretches for the market in history, peaking seven years later. After the first 2005 example, the market did not peak for two years.

This does not mean the low-volatility trade can’t fail. Recently, shorting fear has been a magic money tree on Wall Street. In fact, the last time the haul was better came ahead of the 2008 financial crisis. Then, collateralized debt obligations were held in the same high regard. We all know how that ended.

Near term, the trend is of utmost importance. Right now, all signs point to more of the same. Right now, Jesse Livermore would be short volatility and long the strongest stocks. He would let the market pick winners, dictate direction. That’s exactly what we do in my service Pivotal Point Trader. To find out more about PVT, click here.

Trend-following is one of the primary reasons I dedicated my own research to his guiding principles. It’s too easy to become emotional about stocks. It’s easy to sell too early, or worse, short strong trends, because it feels right intuitively.

This is one of the best investment climates since the last Gilded Age. Important new business models are evolving as technology invades and fortifies old economy sectors. And regardless of your politics, you must recognize that the new White House has set a pro-growth cycle in motion that so far has been impervious to setbacks in its timeline.

My research is focused on finding the winners. Staying with the larger underlying trends is critical. Hang in there with big techs like Microsoft Corp. (MSFT), travel companies like Expedia Inc. (EXPE) and defense contractors like Northrop Grumman Corp. (NOC), and steer clear of energy producers like Occidental Petroleum Corp. (OXY) and retailers like Macy’s Inc. (M).

Don’t worry, be happy.

Best wishes,

Jon Markman

 

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One comment on “Don’t Fear the Market’s Lack of Fear

  1. Jonathan May 8, 2017

    Good article John,

    I am of a mind that though this trend has been going for 8 years and the VIX is at a 10 year low that there is bound to be a short term correction in the markets. The one thing you didn’t mention is that the VIX has gaped down and VIX will fill the gap up or down 100% of the time. Fair trading. Livermore was a genius.

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