Bungee Jumping Is Not For Everyone
The study below originally appeared at Treasure Chests for the benefit of subscribers on Monday, June 5th, 2006.
Are you wondering why US Treasuries have firmed, gold has been creamed, and the dollar ($) is attempting to come to life? (Penned Friday morning) Peter Schiff does a good job of painting a picture in this regard, and according to him, it will involve a great deal of lipstick. And of course we must agree with his assessment / conclusions for the most part, as they appear well founded, but would like to emphasize the success factor of the new dynamic duo could be considerably better than the picture Peter is painting if the reversals in equities engineered over the past few days possess any predictive power. And impressive reversals they are, including the rather pronounced finger painting job (reversal doji) on the Nikki overnight Friday, where it appears it may be in the process of forming a 'head and shoulders pattern' however. So again, while we do not disagree with Peter that Paulson's appointment was well timed and smacks of desperation on the part of Washington, don't expect administrators to play their big trump card and not attempt to give it a good shot at winning the game, especially as far as the next election is concerned.
If this characterization captures the essence of what we should expect out of price managers in the foreseeable future then (no surprises here), and remembering we expect a generally firming environment running into the Presidential Election in 2008, although technical evidence with regard to the equity complex points to a more dire outcome, as pointed out the other day, at a minimum one should count on surprisingly strong recuperative powers in the markets during bouts of weakness. And in fact, we may get a good taste of this right now, where equity speculators that think they are 'in the know' with regard to expectations associated with Paulson's appointment at the Treasury are giving him 'thumb's up' by painting this picture as a 'buy signal'. Furthermore, if this assessment is correct, along with all things equity reacting higher in coming weeks, we should finally see that bounce in the Dow up into the 11,400 area that will present us with that good shorting opportunity talked about a while back in bringing your attention to the recent CBOE Volatility Index Indicator (VIX) breakout. Therein, with this bounce then, we should now see that optimal shorting opportunity outlined at the time.
In expanding on this theme now, one of increasing volatility in stocks that should be expected in coming years, and a significant technical observation / indicator we would like to now bring to your attention that directly affects the performance of the VIX, and hence the broad averages in turn, is the open interest (absolute) put / call ratio for the volatility measure of the S&P 500 (SPX). (Just type in VIX in the symbol box and click submit.) That's right, bankers now sell options on the VIX (it's nice work if you can get it), where again, by and large they are the sellers, banking those premiums every chance they can set against a backdrop of ever-increasing bank credit, which is of course 'the fix' in favor of the house to aid in assuring they never have to payout on this form of insurance. That is to say, the two mechanisms put together aid in maintaining the perpetual short squeeze in stocks that keeps the markets from crashing. Anyway, and just as a low put / call ratio will hamper any security's ability to rally due to sentiment related considerations, because the VIX has been at historic lows for so long now, it goes without saying the probability of a high reading in absolute put / call ratios is minimal, meaning if this doesn't change, volatility should remain subdued, and it's going to have a heck of a time staying over 20 for any period of time.
And you know from the annotated figures in the Chart Room that the large round number at 20 for the VIX is the one to surpass if we are ever to expect a decent correction in stocks. In this respect, if the VIX is finally set to rally, and stocks to swoon, prices are simply testing the break above the 21exponential moving average (EMA) on the monthly, while at the same time 6-year diamond breakouts in RSI, the MACD, and ROC indicators on the daily are also being tested. Implicit in this price action from a classical technical analysis perspective is once this testing has run its course, and assuming failures do not ensue, the VIX should head above the 20 mark in the foreseeable future, certainly not too much longer than the time frames discussed above if the integrity of the present impulse is to be maintained. Again, this is what one should expect under more 'normal' conditions, but alas, and as just pointed out above, there is nothing normal about this situation now with the introduction of these market altering / volatility dampening options. This of course means that as long as liquidity conditions remain supportive, where we don't expect bankers to cease issuing credit tomorrow, a VIX rally over 20 should fail every time, making attempting to capitalize a profit from shorting stocks about as hazardous as bungee jumping, where in fact the markets themselves should react in similar fashion to jumping off a bridge with one of these cords tied to your legs, with the only variable being one of dynamics, or bridge height as it were.
Unfortunately, we cannot give you access to the Chart Room on our site, but we have included a monthly snapshot of the VIX below for your benefit. (See Figure 1)
That is to say, because of the bearish fix options place on VIX propensities, where prices are structurally suppressed due to the orgy of speculation that has now gripped the trade, the current overall absolute put / call ratio is an astoundingly one sided (low) reading of .28 extending throughout all reported series months moving forward into the spring of 2007. This means that as is stands today, the probability of a significant rally in the VIX is nil based solely on this factor, meaning one would be foolish to be excessively bearish on the prospects for stocks because of its importance to the trade. This is why we are always very careful to make sure you understand one should be bullish on both inflation and rising equity prices into decade's end, a view consistent with our larger cycle studies. Furthermore, this is what makes attempting to short these markets so tricky, where one must be quite nimble when opportunities make themselves apparent, because as with the bungee jumping analogy set out above, with current structural conditions in this market as challenging as they are, one must take a profit when it presents itself because if history is a good guide it will be gone in a nanosecond as price managers thwart the effects of gravity once again.
Moreover, and compounding this situation, is the reverse of low put / call ratios seen on the VIX in stock index put / call ratios, where as discussed here many times previously, structurally high absolute values set against US indexes is as important in maintaining buoyant markets as general liquidity conditions. And in putting the two together then, one comes to the understanding that not only do we have high absolute put / call ratios in options on US indexes supporting prices at historically high valuation thresholds, but now, we also have low ratios on the volatility measures traditionally employed to gauge risk suppressing the trade here as well, with the net result a bankers dream of exponentially increasing profits. Thusly, it should be understood that it's this dynamic (situation) set against ever-increasing flows of bank credit / money supply that facilitates all of the bubbles out there, where if these structural constraints were not present, the squeezing action that keeps stock markets supported would be absent, and general price levels would fall. This is of course what will spark the deflationary sequence set to grip macro-conditions as we move into the next decade.
In simple terms then, the question then begs, 'will this condition set ever change?' That is to say, will investors / speculators / institutions ever get bullish on the prospects for the future sufficiently to remove this options related support mechanism from the markets such that they will actually start betting the other way? In a word, the answer to this question is a simple 'yes', but at the same time, there is more to it than just this consideration. What we mean here, which is something we have already pointed out recently, is any market will exhaust itself in terms of extremes, and that we are now witnessing this in the options pits to some extent, where absolute put / call ratios on the Dow and S&P 100 (OEX) have finally fallen below unity for the first time since 2002. This is what accounts for the weakness now being witnessed in stocks more than any other factor next to liquidity conditions.
And as you can see from the bounce in the markets over the past few days however, structurally high insurance related bets placed primarily by institutions to protect their large portfolios have saved the day once again, where if more immediate history is a good guide, put / call ratios on the Dow and OEX should begin rising once again soon too, which will negate the bearish structures (think head and shoulders patterns) now forming on the indexes via an extended short squeeze. This phenomenon is not hard to figure out in that once everybody sees the head and shoulders patterns in the trade, they buy puts to capitalize on a breakdown in prices, but the opposite occurs as officials react to this threat by adding liquidity, sponsoring yet another short squeeze of course. That is the risk one has right now if you are short stocks (long puts), where because of both insurance related buying on the part of institutions, along with speculation by hedge funds and small traders, absolute put / call ratios could rise once again.
As mentioned above however, after years of this kind of thing happening, where at a minimum at least the speculators will abandon what then becomes an obviously flawed investment strategy, exhaustion sets in with regard to this activity due to people going bust by and large, at least until a new population can be cultured. And it is this development, the shear exhaustion on the part of speculators at some point that tips the balance, bearish structures in the tape or not. You see at some point, and unlike institutions that simply invest a percentage of the intake, they simply run out of money. I believe we are at such a juncture right now to some extent, where institutions are still buying insurance related positions on the SPX, but where speculators are becoming increasingly exhausted by this rigged game being perpetuated by the banks. Lest we forget it's the banks that not only sell the lion's share of derivatives based insurance, thought to be in the quadrillions of notional value traded on a global basis, but also control / influence the rates at which bank credit and money supply are issued, which of course sponsors the short squeezes. It's a rigged game you see.
Further to this, let's not forget about their new tool as well, VIX related options, where if it wasn't bad enough before having to worry about index related option based activity and short positions, now we have this added factor, which as mentioned, if stock prices plunge, will cause violent recoveries as investors endeavor to capitalize on their good fortunes by covering positions. And it's this risk a good speculator must be aware of now, where those that are not, and choose to let their put positions run too long will likely end up losing money in the end, even if they are successful at calling a top. Moreover, one can expect to see this structural set-up remain in place as long as the current banking establishment remains in power. So, it's not that one will be unable to make money shorting stocks moving forward, it's just that one will have to be quick to cover your positions once you have made your money, on top of being very precise about when to put those positions on. Of course there is something else you can do, that being forgetting about this type of activity in the first place, simply managing cash levels when it appears a swoon in stocks is on the horizon. As mentioned previously, this strategy is undoubtedly the best one for most folks, where unless you have been around the block with these Wall Street types a few times already in this regard, playing the short side of the market can be a very expensive proposition.
In closing this discussion, we would like to point out that like Rome, where it was not outside forces that finally caused its demise, but the rot from within, sooner or later price managers / bankers / politicos will have used the above described dynamic to it's full extent, meaning they will have rung as much speculation out of the current population as possible, and stock markets (most equities) will ultimately collapse in price. And with regard to the factors that will bring down this house of cards in meaningful fashion in the end, without a doubt investor sentiment as expressed through put / call ratios and short positions will play key roles, as they are the ultimate expressions of how investors see the market in that money must be spent to place a vote. This we see developing as time progresses past 2010, and into the next decade in what can be termed a Kondratief Winter.
Since publication of this commentary on our site back on June 5th, much has obviously occurred in the stock market, including a more profound instance of bungee jumping on the part of stocks that our subscribers directly benefited from. If you are interested in doing the same when the next round of bungee jumping arrives, but are unsure of timing and / or implementation, we invite you to visit our site where you may decide our services are just what the doctor ordered. What's more, while there, you may also discover more about how an enlightened approach to market analysis and investing could potentially aid you in protecting your finances into the future. And of course if you have any questions or criticisms regarding the above, please feel free to drop us a line.
We very much enjoy hearing from you on these matters.