Why We Bought The VIX
The following is an excerpt from our July 31, 2005 market report:
Focusing on key reversals is the primary function of our service. This year we were fortunate enough to have the foresight to be aggressive dollar bulls. Watching dollar bears skewered on the pit was almost as enjoyable as the profits we made for being long from the beginning of January to the end of June.
Below is the chart we showed from the July 31, 2005 Head of the Trend newsletter.
We wrote, "In 1994 a false breakout of a three-year downtrend in the Vix yielded a final selloff to below the 10 handle and below the Bollinger band. This month we saw a long-legged doji occur to the outside of a Bollinger band, which alongside a bullish divergence in momentum measures almost always says a reversal is in!! We bought Vix futures two weeks ago then again this week with 3 to 1 leverage for an expected rally to 20 and potential 300% gain."
Stock Focus: Whenever we put a trade on of this size we follow the train of thought to ask ourselves "how will this play out?" In buying Vix futures we are not betting that the market will go down (though we think it will), but that market volatility will rise substantially on a relative basis.
As longtime readers know we are bullish on hard assets and bearish financial assets like the dollar, which are intrinsically tied to a mountain of debt. However, this did not preclude us from taking a big bullish bet on the dollar this year - one that paid off handsomely!
One of the best indicators for the hard asset / financial asset trend is the Dow to gold ratio. It is amazing how many market professionals are unaware of the simplistic beauty of this ratio. In fact, at this year's Reuters Round Table discussion on the dollar your editor defended James Turk from the PhD types that thought the ratio was ill informed.
Your editor noted at that luncheon that our view at Black Flag is that we should bet on anarchy and chaos to be the norm for the next decade. This is simply the lull before the storm, which is why we bought the Vix at 10.50 and are waiting for a major rally to the 15/20 area in the coming weeks to months. If anyone needs help in purchasing this newly launched futures contract please feel free to email our Introducing Broker desk at firstname.lastname@example.org.
Looking at the Dow to gold ratio in log form we see that real asset prices are basing on a long-term internal trendline. If this breaks down then we should assume to see a spike in volatility. While not expected, if we rally from here then we should also see a spike in volatility similar to 1995 when we broke above that same internal trendline and peaked in 2000 like the previous tops in 1929 and 1966.
Bond Focus: Recall that our "real money" interest rate chart (30-year yield adjusted for purchasing power via gold) completed a very clear "five wave" move down over the past two years, suggesting that a strong move higher in the real cost of borrowing is to be expected. The 30-Yr Bond to Vix ratio is at an all time high and if long yields were to rise and stocks to fall in the coming months the Fed would be compelled to quit raising rates. In turn, that could send the dollar swooning and gold higher as fear in the market grew - thus our buying of Vix futures.
With the yield curve now threatening to invert after another Fed hike (like it was in late 1994 when the Vix last dipped below the 10 handle and the Bond to Vix ratio was at all time highs), we find at every turn our analysis suggests you buy volatility right now. Note that the chart below shows the last time the VIX was below 10, volatility AND yields spiked and the dollar tanked, despite rising interest rates, which the market now perceives as bullish for the US dollar. Whatever the case we are Vix-ed up.
Currency Focus: The above chart in conjunction with our view on the VIX (about to rally) and seasonal trends in stocks (bearish from September to October) suggests that the dollar may decline sharply in September as well - mainly due to seasonal influences of its own. We are looking to buy USDX in the coming weeks on a pullback to 87 but prepared to sell it back to the 85 area later this year.
Therefore, if seasonal weakness should lead to a pullback in the dollar to the key 85 level between September to December we will again be aggressive buyers of USDX around 85 for a renewed advance to the 92 level in early 2006 and a break through this level and a peak around 98 by July/August of 2006. If this seems a complicated mess, simply refer to the chart below for our extended outlook on USD over the coming 12 months. In short, we feel the September-December period will be bearish for the dollar followed by a renewed advance from January to July 2006. If this were to play out, it would set up a MASSIVE head and shoulders pattern and a major short selling opportunity in 2006.