The Fall of 2012

Article of the Week from Investing Daily

by Elliott Gue, Featured Expert, Investing Daily

The stars are aligning for a significant pullback in the S&P 500 over the next two months.

The S&P 500 Volatility Index, commonly known by its ticker symbol “VIX,” has proven a useful market indicator over the years. The VIX, also dubbed the “Fear Gauge,” measures the implied volatility in the S&P options market. When traders are uncertain or panicked about stocks or the economy, the options market tends to price in greater volatility and the VIX spikes higher.

The basic contrarian strategy espoused by the likes of Warren Buffett is to be greedy when others are fearful and fearful when others are greedy. Since fearful markets tend to be an outstanding time to buy, the general rule for trading the VIX is to buy stocks when the VIX is high and sell stocks when the VIX is low.

As with most indicators, the VIX has fallen in and out of favor as a market indicator over the years. A decade ago it seemed as if everyone was watching the VIX; over the past two years I have seen the index receive increasingly less attention. The VIX is far from infallible and does not have a perfect record in timing market swings, but no indicator is perfect. If used in conjunction with other technical and fundamental information, the VIX still is significant value for investors.

Over the past five years, a simple strategy using the VIX has proven profitable: Buy the S&P 500 when the VIX spikes over 41 and sell and short the index when the VIX dips under 17. Over the past five years, this straightforward plan would have generated a total of 7 trades, 4 short sales and 3 longs, producing a total profit of nearly 118 percent. Six of the seven trades would have been profitable. By contrast, an investor who simply bought and held the S&P 500 over the same time period would have generated a gain of just 5 percent including dividends.

Of course, I wouldn’t recommend blindly following any preconceived strategy, but there’s definitely something to it. The VIX slipped under 17 on a closing basis back in March, at around the same time the S&P 500 hit its 52-week highs and just ahead of the market’s 10 percent correction to a low in early June. More ominously, the VIX touched 13.45 on August 17, its lowest close since the summer of 2007. At a minimum, this suggests that investors and traders are complacent about the market and we’re a long way from the panicky trading environment that typically signals a major buying opportunity.

From a fundamental standpoint, the driver for the recent rally is growing expectations for significant additional stimulus from the US Federal Reserve and that’s a shaky foundation.

Source: Bloomberg

In a normal market, US government bond yields and the S&P 500 should be move in the same general direction. In other words, when the yield on a 10-Year Treasury bond yields is rising that means that investors are selling US government bonds. Since US government bonds are considered a safe haven investment that traders typically buy when they’re worried about stocks and other assets, a rising bond yield typically means that investors are becoming more bullish about general economic conditions. In addition, money that’s moving out of bonds is probably finding its way into other assets classes such as the stock market.

Similarly, when bond yields are falling, investors are buying government bonds and driving the yields lower. This suggests that investors are running away from risk into the safety of what’s historically the safest asset class of all.

For example, a year ago in August and September of 2011, US 10-Year yields collapsed to under 2 percent despite the first-ever downgrade to America’s sovereign credit rating. Investors rushed for the safety of bonds and sold off stocks so yields and the S&P 500 collapsed in tandem.

Last spring, as the S&P 500 rose to multi-year highs, we began to see a spike in 10 –year Treasury yields, a sign of growing optimism in the strength of the recovery. Then, once again, yields fell as the economic data weakened in April and May, pulling stocks lower as well.

However, since June, this well-worn relationship between stocks and bonds has largely broken down. While US government bond yields have dropped to their lowest levels in over 200 years, the stock market has rallied to near four-and-a-half year highs. Investors are buying both bonds AND stocks.

The explanation for this inconsistency is that investors are buying bonds in anticipation of a third round of Fed quantitative easing (QE3) this year. Investors are speculating that the Fed will seek to push down yields even further by buying additional Treasury bonds and, quite possibly, buying other types of securities such as mortgage-backed bonds. The market is also making the play that additional easing by the Fed would be bullish for the stock market, just as it was when Fed Chairman Ben Bernanke announced a second round of quantitative easing in the summer of 2010.

The problem with this reasoning is that investors face the potential for multiple significant disappointments over the next few months. First and foremost, stocks have already rallied to price in QE3; the consensus expectation is that the central bank will announce the additional easing at its September 12-13 scheduled meeting.

I’m expecting the Fed to launch QE3 as well. If there was much doubt before Ben Bernanke’s speech in Jackson Hole, Wyoming on Friday, there should but none now, after his somber warnings about stalled economic growth. The big question is the timing. There’s a significant chance the Fed will wait a few more months and watch the incoming economic data before announcing QE3.

It’s also possible Bernanke wants to avoid being seen as politicizing monetary policy and will wait until after the November elections to announce QE3. If the Fed doesn’t announce significant additional easing measures during its September meeting, disappointed investors will drive the market sharply lower.

Moreover, the S&P 500 is already pricing in QE3. There’s an old saw on Wall Street: “Buy the rumor; sell the news.” In other words, investors buy in anticipation of an event and then often take profits once the expected event actually happens. So, even if the Fed does announce QE3 in September, there’s a significant risk traders use that as a cue to take some gains.

And then there’s Europe. Sovereign debt markets in Italy and Spain have been remarkably well-behaved this summer primarily due to a promise from European Central Bank (ECB) President Mario Draghi that the central bank will take steps to ease the euro crisis. That means that Draghi is expected to announce a plan to buy the debt of Spain and Italy to force down yields.

Several prominent German policymakers have made little secret of their distaste for this policy, because it smacks of debt monetization. In addition, German voters will likely see ECB bond buying as another bailout that lets fiscally irresponsible EU countries off the hook without demanding significant new reforms and austerity.

In my view, the ECB will buy bonds even with German opposition. But European policymakers have disappointed the market on countless occasions over the past two years. In fact, EU leaders appear to be masters of over-promising and under-delivering. Typically, European leaders have only reacted when there is the risk of a true crisis such as a country leaving the euro, yields spiking to record levels, an imminent banking collapse or stocks tanking.

Europe has been in rough shape this summer, but it hasn’t fallen into a full-blown crisis as it did last year. Regardless, the market remains irrationally optimistic about new EU policy measures to address the region’s sovereign debt crisis.

I’m looking for a major, broader market correction over the next two months. Investors should consider taking profits on stocks that are trading well above my ‘buy under” prices. I also recommend focusing new investments on defensive groups such as the consumer staples and health care industry groups. Finally, investors should favor large companies and those offering significant yields.

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