Many investors look to past history as an indicator of what will occur in the future. While this approach does not offer clear, decisive answers, it does provide lessons we can apply to the future. One lesson I have learned is that parabolic rises eventually collapse and investors who get short at the right moment will be rewarded.
The only problem with that approach is determining the right moment. Short the stock too early, and you will be wiped out before your thesis is proved correct. After all, how many investors went short the
near 4000 in February 2000 to only see the position move 25% higher before collapsing? As with all investments, entry point is everything.
Over the last three months, very little has worked. Short=sellers have clearly profited, but as stock prices have collapsed staying short has become too risky. Instead investors have searched for safety as fear has overwhelmed greed. While I understand the need for safety, this trade has become so crowded that we now see parabolic rises that are set to collapse.
I will focus upon two distinct instruments to highlight the safety trade -- U.S. Treasury bonds and the CBOE Volatility Index. Treasurys are the safest of all investments. Investors believe the U.S. government will never default and rush toward their bonds as fear increases. Lately, the rush has become a stampede. As investors focus on return of principle over return on principle, prices have skyrocketed with Treasury yields at historic lows.
Volatility is the lifeblood of the option market. All else being equal, high volatility leads to increases in option prices and low volatility leads to declining option prices. VIX measures option volatility. Since options are often used as a way of insuring a portfolio against loss, VIX has become known as the fear index. When VIX is high, options are expensive and the cost of insurance increases as people are fearful that stock prices will collapse. With collapsing prices all around us, it is not surprising that VIX pushed to record highs.
Understanding why the fear trade has worked, what could cause a reversal? There are two distinct factors -- one technical and one fundamental. For the fundamental reason, turn to the UST market. To combat the threat of deflation, the
has flooded the banking system with unprecedented amounts of dollars. As the printing press operates at full speed, the Fed has offered nearly $8 trillion of loan guarantees through various lending programs. As markets deleverage, the Fed has acted to prevent widespread deflation from crippling the economy. This deleveraging has slowed the velocity of money and prevented inflation from taking hold. However, the Fed will eventually succeed in halting deflation and be left with a massive amount of excess dollars in the banking system. The end result will be swift inflation.
As for the VIX, we now see clear technical patterns that point to a collapse in volatility. Since bottoming at 16.3 on May 15, VIX has spiked as high as 80.9 and currently trades at 58.5. Over the past two months, VIX has carved out a head and shoulders top and is in process of violating a key uptrend. When this violation occurs, I expect VIX to collapse toward 30 over the coming six weeks.
So how do we synthesize all this information into a trade? Falling VIX will be bullish for stocks, but why bother with second derivative ideas? Currently, individual investors have a way of profiting from both falling bond prices and falling VIX. As highlighted in my
, inverse ETFs offer a way to profit from falling bond prices and VIX options allow you to profit from falling VIX. As the fear trade unwinds, consider
ProShares UltraShort Treasury ETF
and out of the money VIX puts. TBT offers a leveraged short of the UST market as TBT increases in value at twice the rate the long bond falls. The January 55 VIX put (VIX+MJ) offers tremendous optionality. If VIX falls toward 30 by mid-January, these options offer a 7-to-1 payoff.
For the past three months, the fear trade has offered great protection for investors. However, all trades run too far in one direction and eventually collapse. VIX and UST have gone too far and opportunistic traders using ETFs and options can profit from the eventual unwinding.
At the time of publication, Sean Hannon had no positions in stocks mentioned. Positions may change so
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