Chart Of The Day: VIX

The VIX index (a measure of implied volatility) put in an amazing performance on Friday, rocketing 24% higher on the session. The index had been trending lower since peaking just north of 80 in late December of last year. On October 21st, it reached its lowest level since September of 2008. Not coincidentally, that was also the day of the stock market's most recent peak. The volatility of volatility was pretty dramatic in October.

Disclosure: Things had become a little too calm for our liking. We initiated a long volatility position on October 19th to increase our hedge position.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Bear Rally Chatter and Strategy Update

This market continues to favor traders and thrill seekers. I've talked about fading this market a number of times in the past few months, and, at the margin, that's what I've been doing. The basic rule has been simple: when my wife has had to talk me off the railing of our one-story deck, its time to buy, and when I start doing Schwarzenegger impressions, it's time to short. Recently, I've been doing Schwarzenegger impressions on the deck railing.

In mid-late November, I added positions in UWM and QLD as the market was again rolling over and the VIX (fear) index was once more spiking towards record levels. Since that time the number of market professionals looking for a bear market rally seems to have grown by the day. I've read quite a few of them just this week talking about a rally into early next year, even those who are very bearish. I'm a bit surprised by the timing of these calls considering that the market has already rallied 20% from its intraday low on November 21st. There's nothing like a good rally to bring out a bunch of predictions for...a rally. The lemmings that went over the cliff are climbing back up for the next jump.

Bear market rallies much greater than 20% aren't exactly common. That certainly doesn't mean that the current rebound can't go significantly higher. Recall, we had a 50% rally during the Great Depression, so there is precedent for very powerful upward moves during bear markets, but these types of moves are very unusual.

In fact, some of the strongest short-term market rallies tend to come during bear markets. It's easy to understand why: fear and greed. On the one hand, the market tends to get oversold in the short-term as fear of a job loss, insolvency, plague, and children who may never leave home grips the masses, and wholesale selling ensues. At the same time, investors who've lost a lot of money are eager to jump on any potential rally that may help them recoup some of their losses in order to help their child with the security deposit on their first apartment. And you never know, the next rally could be the beginning of the next bull market. Who wants to be the idiot who sold at the bottom and kept waiting forever for another chance to buy at those levels?

Back to the present. With a 20% rally already in hand, I have to believe that the easy money from this leg up has been made. That doesn't mean that the market can't go higher, but I'm back at what I call "an inflection point moment." I can't bring myself to add more general market exposure given the move we've already had (though I'm always scouting for individual company opportunities), yet the move up isn't so overdone that there's a clear signal to sell. Unfortunately, I'm just not smart/foolish/prescient/daffy enough to try and call market tops or bottoms, particularly those of a short-term nature. As a result, in this type of environment I tend to build marginal market long and short exposure as the strength or weakness of the market accelerates.

In keeping with that, I haven't yet sold the QLD or UWM positions, but they will be jettisoned should the market rally much further. In the meantime, I'm willing to give them a little more time as the market has finally been responding well to bad news. I have, however, recently added some modest new short exposure in the real estate area. This is partly due to the fact that this sector has had one of the smartest rebounds during this latest market rally. With the market up 20% from its lows, many real estate ETFs are up closer to 50%. This is a logical pool for bottom fishing given the degree of damage we've already seen, but I'm of the opinion that this sector will see further downside, particularly commercial real estate. The current short position is modest, and my intent is to increase the short side of the portfolio (and reduce longs) should the market rally continue.

This particular rally has been gratifying in that many of our core positions in the commodity, mining, industrial, and precious metal sectors have had nice moves. The recent decline in the U.S. dollar from ridiculous levels hasn't hurt. Many of the names/positions in these sectors are trading at very attractive valuation levels for those willing to look beyond the next few days. I've been gradually adding to this space during the downturn and expect to be very pleased with their performance over the next 5-10 years. In the near term, however, they won't be immune to the next sell-off in the market (at which time I'll be adding to them).

Disclosure: The Rubbernecker is long, short, and inflecting.

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The Market Rubbernecker is affiliated with Aspera Financial, LLC, a registered investment advisor. Please read the disclaimer on the home page of the Market Rubbernecker site.

Tis The Season

It's been a slow week posting-wise thanks to a busy week earnings season-wise. Earnings season is always a bit of a mind-numbing experience. Every day is met with a barrage of press releases, numerous analyst rating changes, and back-to-back conference calls with management explaining how their quarterly earnings would have been an all-time record if you just ignore the write-offs, higher commodity costs, lawsuits, accounting system transition issues, margin shortfall, higher tax rate, options expense, weather impact, goodwill amortization, order push-outs, and poor feng shui. It makes for some long days.

Of course, there are companies reporting good earnings -- mostly commodity-related companies, those benefiting from international growth and the weak dollar, and those that operate pawn shops. Those with the most excuses are the financials. The typical bank conference call this quarter can be summed up as follows:

We’re disappointed to report a record loss of 12 kajillion dollars, but our core business is performing strongly as you can see if you strip out the mark-to-market losses and the charge-offs.

Well, if I ignore my lack of buoyancy and my inability to breathe in the water, then I'm a world-class swimmer. They’re a bank! The purpose for their existence is to attract deposits/funds and invest the proceeds in securities and loans. It’s like Microsoft saying, “We had a great quarter aside from terrible software sales.”

Let’s be very clear. When a bank has to charge-off a good chunk of its loans, it's an admission that prior period earnings were overstated. Prior earnings benefited from these loans back when borrowers were actually making their payments and the bank wasn’t adding to reserves. These guys want the benefit of the overinflated prior period earnings but no penalty for the current period charge-offs. It would be genius if it weren't so ridiculous.

Despite some truly poor earnings in general from the financial sector this quarter, we did witness a very robust rally in the group. This wasn't terribly surprising. As I wrote on July 15^th in my Trader VIX post,

...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.

It seems I wasn’t the only one watching the VIX. Almost as soon as the VIX crossed 30, the market made its most recent low and began its latest bounce. With financials having been sold-off so brutally over the prior 2 ½ months, it was no surprise that they benefited the most from the rally.

Also from the Trader VIX post,

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.

This also turned out to be the case. Prior to Thursday, the S&P 500 rallied more than 6% over a mere 6 trading days. Generally speaking, the earnings results from the financials were awful, but since they turned out to be less terrible than feared, the group enjoyed a powerful rally.

The other strong move of note this month has been the sell-off in practically every commodity and commodity-related company. I’ve been cautioning that this would happen at some point and that this is normal bull market activity. I had pared back exposure to the group and have been keeping some dry powder ready for just such a pullback.

In recent days, I’ve been gradually putting some of that dry powder back to work, adding to some energy, metals, and agriculture names. I anticipate adding further should investors continue to bail out. As for the financials, I've had no interest in chasing the latest rally. For now, I'm on the sidelines, but should the group rally further, I'll be looking to rebuild a short position in the sector.

My writing is likely to continue to be a little thin over the next couple of weeks since we're in the meat of earnings season. I'm not as effective or coherent a writer when I'm in an earnings release-induced state of catatonia.

Disclosure: The Rubbernecker is long commodities and caffeine and very short sleep.

Trader VIX

S&P 500
VIX

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.