Capitalizing on Fear in the S&P 500

The S&P 500 is within spitting distance of the 2007 highs. Remember 2007 when the economy was rolling along and everyone used the equity from their first house to buy a second or, third? Home ownership became everyone’s entitlement – the American way. Five years of deleveraging later and we’ve figured out that corporations know how to manage their businesses better than the bureaucrats know how to run our economy. Corporate balance sheets are healthy and Interest rates are at all time lows. Unfortunately, the government can’t figure out spending for a quarter, let alone an entire fiscal year.

We have written extensively on the topic of using stock index futures to hedge your retirement account. Typically, the response is, “How can I sell something I don’t own?” This week we are going to discuss Volatility Index futures. This is a product offered by the Chicago Board Options Exchange and it trades opposite the stock market. Therefore, buying VIX futures provides protection from a downdraft in the stock market while simultaneously limiting the risk of the hedge position.

First, it’s important to understand that volatility in the stock market is primarily associated with fear. Stock market declines put fear into the market’s participants. Fear generates wild swings in the market. Therefore, volatility increases with fear. The stock market collapse of 2008 was even wilder than the post tech bubble crash of 2000. The winter of 2008 saw the average monthly range in the S&P 500 increase to more than 145 points per month. This meant that the stock market had an average range between the month’s high and low of more than 20%. This continued for eight consecutive months.

VIX futures trade monthly and they are a direct measure of the volatility expected within the next 30 days. Therefore, if the price of the VIX futures is 17.00, the market expects that the S&P 500 futures may move as much as 17% over the next 30 days. The all time high for the VIX futures is 80.86, set in November of 2008.

This leads us to the second point. Fear is an emotion. Emotional actions exceed rational behavior in the markets. The all time high in the VIX futures suggested that the market could be priced more than 40% higher or lower from the prices we were trading at the time within 30 days. The S&P 500 closed at 812 in November of ’08. The VIX price suggested that by Christmas, we could’ve been trading as high as 1136 or as low as 487. The reality was that we traded from a low of 730 to a high of 836 in December of 2008. Clearly the imagination of the market’s participants got the best of them.

VIX futures are also an easy market to conceptualize in both pricing and movement. The current price is the market’s expected volatility between now and the expiration of the contract. The April VIX futures are trading at 16.50. That implies a volatility envelope of 8.25% higher or, lower. Volatility must be measured as a +/- envelope.  This suggests that the S&P 500 futures, which are currently trading near 1484, should be between roughly, 1606 on the high side and 1362 on the low side when the April VIX contract expires. The all time high for the S&P500 is 1695 in March of 2000 and the market hasn’t traded above 1600 since September of 2000.

The pricing of VIX futures is simply $1,000 multiplied by the index level. The April VIX futures trading at 16.50 has a full contract value of $16,500. This represents a multi year low. The all time low was 12.77 set on May 11th, 2007 while the previously mentioned all time high of 80.86 goosed the full contract value up to $80,860. May, 2007 was the same month that the S&P 500 traded back above 1500 for the first time since the 2000 tech bubble burst and should help to provide an apples to apples comparison of the relationship between the VIX futures and the broadest stock market benchmark, the S&P 500. The real key is that while the S&P 500 declined by 50% for a potential loss of $37,500 between May of ’07 and March of ’09, the VIX futures surged by more than 600% or, a potential profit of more than $68,000.

The trade that we are looking at hinges on two ideas; One, that political discord among the bureaucrats in charge of the U.S. budget will find a way to add some drama to the markets or, secondly that buying the VIX futures provides a supported position with limited risk as a hedge against another 50% decline in the stock market.

The 3.73 point difference between where the April VIX futures are currently trading and the all time low of 12.77 equals a potential loss of $3,730 dollars per contract, which is about equal to a minimal 5% decline in the mini S&P 500 futures at $3,710. However, any decline more serious than that could set the market’s emotions roiling and we’ve already illustrated the excess returns achieved through owning volatility futures, rather than outright shorting of the stock indices.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Not Quite Time for Gold to Shine

The gold futures market is still looking for support since reaching a high near $1,800 per ounce in early October. The market had fallen by nearly $200 per ounce as recently as early this month. Fiscal cliff issues as well as tax and estate laws fueled some of the selling. However, commercial traders were the dominant sellers above $1,700 per ounce as they sold off their summer purchases made below $1,600. I believe the gold market has one more sell-off left in it before it can turn higher with any sustainability.

Comparatively speaking, gold held its own against the Dow in 2012 with both of them registering gains around 7% for the year. However, the more nimble companies of the S&P 500 and Nasdaq soundly trounced the returns of each, registering gains of 13% and 16%, respectively. The relative advantage of gold in uncertain times may be running its course. There currently is no inflation to worry about and CEO’s are learning how to increase productivity to compensate for increased legislative costs. Finally, the S&P has risen by about 19% over the last 10 years while gold has rallied by more than 250%. Therefore, sideways market action in gold over the last couple of years seems justified.

Meanwhile, seasonal and fundamental support for gold hasn’t provided much of a kick over the last two months. Typically, the Indian wedding season creates a big source of physical demand in the gold market from late September through the New Year. In fact, the strongest seasonal period for gold is from late August through October in anticipation of this season. This effect should be gaining strength due to the rise of the middle and upper middle classes in India yet, the market seemed to absorb this support with nary a rally to be had. I think we’ll see the market’s second strongest period, which begins now, and runs through the first week of February provide us with a tradable bottom and rally point.

Finally, the last of the short-term negatives is the strength of the U.S. Dollar. The U.S. Dollar trades opposite the gold market. Gold falls when the Dollar rallies because the stronger Dollar buys more, “stuff” on the open market and while we’ve talked about commercial traders buying gold, they’ve also been buying the U.S. Dollar Index. Commercial traders have fully supported the Dollar Index at the 79.00 level. The Dollar Index traded to a low of 79.01 on December 19th followed by a recent test of that low down to 79.40. The re-test of the 79.00 low has created a bullish divergence in technical indicators suggesting that this low may be the bottom and could lead to a run back to the top of its trading range around 81.50. This can also be confirmed in the Euro Currency and the Japanese Yen. The Euro currency futures market has seen commercial traders sell more than 120,000 contracts in the last six weeks as the market has rallied from 1.29 to 1.34 per Dollar. Meanwhile Japan’s new Prime Minister, Shinzo Abe, has turned the country’s monetary presses up to 11 in an attempt to jump-start their domestic economy.

The absence of an expected rally in the gold market through the last few weeks leads me to believe that the internals simply don’t support these price levels, yet. Therefore, the market will continue to seek a price low enough to attract new buyers beyond the commercial traders’ value area. Typically, this would lead to a washout of some sort that may force the gold market to test its 2012 lows around $1,540 per ounce before finding a bottom.

Furthermore, the flush in gold would most likely be accompanied by a rally in the U.S. Dollar and could push it back above the previously mentioned 81.50 level. Proper negotiation and resolution of the pending debt ceiling would most likely exacerbate both of these scenarios while also including a large stock market rally. Conversely, a legislative fiasco would lead to a Dollar washout, as the global economies would lose faith in our ability to manage ourselves and treat our markets accordingly. Therefore, in spite of the inter-market, fundamental and technical analyses we will keep our protective stops close on our long Dollar position while waiting for an opportunity to buy gold at discount prices for the long haul.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.

Forcing Democratic Spending Cuts

The resolution of the fiscal cliff did little to address the primary issue of governmental spending and increasing deficits. The end result was an easy sound bite for the President, “I promised not to raise taxes on working Americans, continued the extended unemployment program and forced the wealthy to pay their fair share.” I was surprised the republicans gave in so easily as I read the details of the resolution, primarily because the sequester and debt ceiling issues were completely sidestepped in the negotiations. I just assumed it was politics as usual and that means kicking the can down the road as long as possible.Current estimates are that we’ll hit the debt ceiling around March 1st, give or take two weeks. Congress’ inability to hash out an agreement on the last debt ceiling increase was a primary cause for the first credit downgrade in U.S. history by ratings agency Standard & Poors. It now appears that the Republican Party conceded the fiscal cliff battle in an attempt to win the debt ceiling war. The Republican mantra throughout the fiscal cliff discussions focused on a Dollar for Dollar balance of spending cuts vs. tax hikes. Their concession to the final deal kept them from becoming the scapegoat in a game of political brinksmanship. This round of debt ceiling talks promises to be an all out war between the President and the Republican Party. The sequester will automatically kick in if the debt ceiling is not raised and this appears to be the Republican strategy for getting the spending cuts they wanted in the fiscal cliff negotiations. It’s important to remember that President Obama signed the sequester bill into law as part of the 2011 Budget Control Act. At some point, the Democratic Party must realize that it cannot continue to buy votes through endless entitlements. The Republican Party appears to have already come to grips with this, as sequestration would immediately trim more than $54 billion dollars in defense spending for 2013. The political gamesmanship taking place appears to have now put the pressure back on the Democrats. Odds are, the President assumed that the Republican Party would call for a replacement of the sequester to avoid the defense spending cuts associated with its implementation. The President would then use this to leverage his domestic spending desires. However, Republican silence on replacing the sequester shows that the Republican Party may have more support from its constituents than initially assumed. House Speaker, John Boehner has indicated that he has significant support, going so far as to say, “I got that in my back pocket,” referring to the support of Republican defense hawks. The Republican Party’s ability to finally form a consensus now forces the Democrats to come to the table with their own domestic spending cuts. The reasoning is that the Democrats would rather pick and choose which programs get cut and by how much as opposed to the blanket cuts imposed by sequestration. Meanwhile, the Republicans appear to have accepted that the sequester may be the only way to cut spending. This implies that they’ll be less likely to concede the debt ceiling negotiations as easily as they did the fiscal cliff.This brings us to Democratic wiggle room and the technical loophole of, “seigniorage.” Seigniorage is the difference between the physical cost of producing currency and the face value of the currency itself. Therefore, if it costs the government $.02 to produce a nickel, a $.03 profit is made by the Treasury through seigniorage. The President can use this to avoid the debt ceiling discussions altogether while the Federal Reserve and the Treasury Department quietly work behind the scenes in an attempt to keep our country afloat. This started out simply enough in the 1997 legislation that authorized the production of the 50 state quarters. According to Public Law 104-208, “The Secretary may mint and issue bullion and proof platinum coins in accordance with such specifications, designs, varieties, quantities, denominations, and inscriptions as the Secretary, in the Secretary’s discretion, may prescribe from time to time.” The unintended consequence is that it technically provides the Secretary of the Treasury, Timothy Geithner with the ability to produce a platinum coin and assign it any face value he chooses.We’ll wrap this up with this dramatic scenario. Tim Geithner has vowed to do everything within his power to ensure the U.S. economy continues operate as the most liquid and transparent depository in the world. The speculation is that he could mint a $1 trillion dollar platinum coin and deposit it with the Federal Reserve so that the Treasury could continue to make the payments it’s already obligated to. These would include Social Security, Medicare, Medicaid, education, air traffic controllers, national parks, food stamps, etc.These payments are already preset in the government computers and systems to go out as usual. A failure to reach a decision on the debt ceiling would force every one of these protocols to be re-written and choices to be made regarding who gets paid and who doesn’t. Those seeking to collect would also include foreign holders of our Treasuries. Can you imagine the public outrage if the government chose to repay Chinese debts over Social Security funding? Can you imagine the global economic crisis that would ensue if we chose to fund Social Security over Chinese debt?Finally, the argument that this would be hyper inflationary is simply ignorant. The coin would be deposited at the Federal Reserve. The Fed would instantly use it to buy U.S. Treasuries thus, sterilizing the $1 trillion Dollar coin economically. The primary point is that we are straddling the political and economic fence between hapless and malevolent. Hopefully, the fence pikes will be uncomfortable enough to force a resolution.

Feel Good Politics

“The government faces some very tough decisions in the months ahead. The very real concerns over the growth of our own debt must be balanced against the need to nurse the recovery along. Washington deserves to hear our voices as we express our own opinions on the amount of debt we’re willing to carry versus the benefit we’ll receive from its creation. The most important thing is that we force them to recognize the very real issues at hand and not allow them to sit by idly as our economy pushes towards our own unsustainable European outcome.”

That was my closing paragraph in December of 2011. Apparently, the politicians were too busy with re-election plans throughout 2012 to do any damn thing about any damn thing other than ensure their own welfare, care packages and raises in 2012. Fiscal Cliff? Debt Ceiling? Payroll Tax Extension? Tax Reform? It’s starting to look like half of our governing officers jackhammer potholes just so the other half will have something to fill. Meaningful legislation and the idea of elected public servants has simply become a yearning for the, “good old days.” The reality is that this is exactly the same type of yearning that guarantees the perpetuation of this futile cycle.

The grandiose version of this cycle is that we should all have everything we want, when we want it. It’s been pounded into our brains through mass marketing that tells us we NEED their new product. It’s been made available to us through buy now pay later, lay away, credit cards, refinancing and high interest paycheck loans. Finally, our government who encourages us to spend, spend and spend endorses it. Everyone deserves to own a home and the only reason 98% of us don’t have more is because 2% of us have too much. Frankly, we’ve become an insatiable society that feeds off the entitlements garnered by our individual representatives.

The psychology behind the society we’re quickly becoming is best viewed through Dr. Loretta Breuning’s satisfaction experiments with monkeys. The applicability of this train of thought requires the general public to assume the role of monkey and we’ll place the government in the role of experiment coordinator, Dr. Loretta Breuning. She showed that monkeys fed the same diet are perfectly happy and well adjusted. She then adjusted the flavor of the leaves in their diet to be super tasty. The monkey’s appreciate the new flavor and quickly favor it above all other foods. The final step is the monkeys’ observed behavior when the leaves are returned to their normal flavor. The monkeys react with rage, even though they were perfectly happy with the same leaves prior to the experiment.

The exaggerated negative response to the leaves returning to their original flavor clarifies the human principle that losing something that was given elicits a much stronger response than unexpectedly gaining something new and pleasurable. Our minds focus on what we’ve lost, rather than what could be. Similarly, benefit programs and economic stimulus generate a much stronger negative response upon their repeal than the positive response generated upon their implementation.

This axiom holds true at the individual level as well as for the economy as a whole. This experiment, in greater detail, also showed that the positive effects of the new flavor were short lived. Therefore, positive reactions diminish much more quickly than the negative ones. This aspect of her work compares favorably to the diminishing returns of economic stimulus programs. For example, there have been three rounds of quantitative easing. Each round has provided a smaller bang for the buck than the previous round. Comparison in an apples to apples format would show that when we as individuals and when the economy as a whole expects another handout, the less we appreciate what we’ve already been given. However, the removal of those handouts will create an alarm that rings far more loudly than the chorus of, “thank you,” could ever be.

The politicians from small towns to Washington D.C. are all aware that their livelihood rests upon election. Therefore, in their own self-preservation they must introduce more special interest bills to replace the specially flavored leaves of the previous administration and heaven forbid they should try and take away what has already been given. This is what the, “fiscal cliff” has brought us. “Grand Compromise?” Hardly.

The agreement to raise taxes on the top tier and extend the unemployment benefits has done nothing to solve the cultural dependency of handouts for votes that has gotten us into this mess to begin with and will increase the Federal debt by $4 TRILLION over the next decade, according to the Congressional Budget Office. The votes bought by the politicians and paid for by us continue to push us deeper and deeper into the same economic ditch as the European socialist governments.

This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.