Tuesday, July 15, 2008

Trader VIX

S&P 500

As you may know, I'm not a huge fan of aggressive short-term market calls. Well, it's not the calls so much as the people making them. I'm also not particularly enamored with those who spend their time trying to call market bottoms and tops. Believe me, if they really had any skill at it, they wouldn't be sharing it with you. They'd be holed up in some windowless cell at Goldman's headquarters surrounded by enough computer horsepower to simultaneously manage our nuclear weapons arsenal and run Guitar Hero 2 while the eerie glow of dozens of computer monitors slowly sucked their souls out of their catatonic, colorless, withered carcasses. But I digress.

My "short-term" trading is rarely by design. Rather, it's the result of opportunities presented by Mr. Market. I might intend to hold a security for a few years, but if the crowd drives it well above fair value in a short period of time, I'm not averse to at least taking some of the position off the table. Conversely, if the thesis behind a security purchase quickly evaporates, that security and my portfolio will immediately be parting ways regardless of the length of their relationship.

There is, however, one short-term indicator that I do keep an eye on when thinking about a portfolio's overall long/short position, and that's the VIX index. The VIX index (second graph above) refers to the Chicago Board Options Exchange Volatility Index, and it's a measure of expected volatility for the next 30 days. It's commonly known as the investor fear gauge and is derived based upon the implied volatilities of various S&P 500 index options. In English, when the VIX is rising, investors are taking short, shallow, rapid breaths, cursing their brokers, and heading back to church. When the index is falling, investors are becoming less jittery, regaining continence, and once again putting complete sentences together.

As you can see from the two charts above, the VIX has had an uncanny ability to predict short-term rallies (lasting between 2 weeks to 3 months) in the S&P 500 (top chart) each time it has exceeded 30 in the past year. As the VIX has approached this level, I've been less inclined to initiate new short positions and more inclined to cover existing shorts. Note that the intraday high for the VIX today was 30.81.

Just as bull markets experience retracements, bear markets experience rallies. Even though the sentiment and news in the market right now is fairly dismal, we may be setting up for a repeat of last quarter's earnings season in which bad earnings reports and guidance actually drove the market higher simply because the news turned out to be less horrific than feared. Don't get me wrong. In general, I'm expecting plenty of earnings misses and fairly restrained (to put it mildly) earnings guidance over the next month. But, with cash on the sidelines and a pervasive sense of gloom in the market, an earnings season short of cataclysmic may be just enough to spur the next bear market rally.

So am I making the type of short-term call that I despise? If so, it isn't worth the paper it isn't written on. I prefer to think of it as a tactical, contrarian, rebalancing opportunity. I know. I know. You say tomato, and I say tactical, contrarian, rebalancing opportunity. I'm not making wholesale changes to any portfolios. I'm simply taking profits on short positions that have performed well and are now less attractive from a risk-reward stance.
I'm currently sitting with the smallest short position I've had in a few months. Should the VIX continue to rise (and the market fall), I'll be very likely to exploit further tactical, contrarian, rebalancing opportunities.

Disclosure: The Rubbernecker is long semantics and short the interpretation of the meaning of words and phrases.