Is the Market Setting up for a Big Collapse?

As the broad markets are slowly inching their way to the cyclical and multi-year highs made this spring, are you beginning to get suspicious that the next shoe is about to drop and we’re in for a hefty sell off?

It makes perfect sense to feel this way right now, particularly with all the headline risk that’s swirling around from virtually every corner of the globe.  And besides, the bull market is starting to look a bit “toppy” after such a protracted run.

As a former equity options floor trader, I was taught very quickly to always be skeptical about the market landscape -- in essence, to always keep “one eye open while I sleep” and never become overly complacent.

But I also learned to see the market landscape as it is.  In other words, to “keep it real” and trade what the market is “telling me”.  And if the market would indeed signal a potential shift, I would then make the appropriate adjustments in strategy and overall sentiment.

A great tool to help me gauge the current market landscape and potentially the near term future is looking at volatility, or the “fear premium” in the market place.

The most commonly used instrument to assess investor fear is the VIX.  The VIX is an index that measures implied volatility on option premiums on the S&P 500 index that are roughly 30 days from expiration.

If you’ve been following me in The Tycoon Report, you’ll recall my March 15, 2012 article, Higher Volatility Coming Sooner Than You Think, in which I predicted that higher volatility was on the near term horizon and a significant stock market pullback could be coming.  The VIX was very low at the time, at 15.31, but the VIX futures curve was extremely steep and commanded a much higher premium.  This was a warning sign that the market was pricing in some serious headwinds in the near future which couldn't be seen by simply looking at the spot VIX.

I pulled the table and graph from that article that showed a low VIX but a steep futures curve:


Less than three weeks from the date of the article, the broad markets did indeed hit their peak and proceeded to sell off over the next three months.  Volatility and fear spiked as the S&P 500 declined 10% and brushed correction territory.


So let’s fast forward to the present.  The broad equity markets are once again approaching the highs we’ve seen around the time of my March 15th article.  And the spot VIX closed on Wednesday at 15.32 -- a nearly identical reading (just one hundredth of a point higher in fact)!

Now let’s look at the VIX futures and analyze the curve over time.  I pulled the data from the CBOE website and you can also access this information for free anytime you wish (www.cfe.cboe.com).

The following Table and Graph show the term structure in spot VIX and VIX futures through year end...
 
 

What sticks out to you the most when you review the table and graph, especially when compared to our springtime analysis on volatility?

The spot VIX is virtually identical, but the futures term structure has changed.  The curve has flattened significantly as you look out over the next several months.

Essentially, the smart money has priced future volatility much differently than this past spring, and this can be quite telling in terms of how the next few months might transpire.

Lower volatility generally coincides with a bullish environment and reduces the probability for large stock market declines.

Even despite the uncertainty in Europe, the upcoming US presidential election, and a looming fiscal cliff that could see massive tax hikes and sharp spending cuts go into effect in less than five months, the forward pricing of risk implies a much calmer market landscape.

And while we are overdue for some type of pullback, the weakness will most likely continue to be shallow, brief, and of the sort that attracts buyers on the dips.

The bottom line is that no one can predict the market landscape with absolute certainty, but this simple analysis on volatility certainly implies that if we do see another correction style sell-off, it will most likely be kicked down the road sometime after the end of this year.

Costas Bocelli
Contributing Editor
Channel Trading Secrets