The past few weeks have been
full of a constant barrage of press conferences and public statements from
the charlatans in Washington D.C. Politicians cannot pass up a chance to get
in front of the cameras and the media has used the "fiscal cliff"
as a mechanism to scare average Americans further about their future.
Interestingly enough, amid all
of the nonsense that has been going on stocks have remained resilient. I
think sometimes its important to just step back away from the media's noise
and just look at some price charts for more clarity. The S&P 500 Index
has been trading in a relatively tight range now for over 6 trading sessions
as shown below.
As can be seen above, the
S&P 500 is struggling to breakout of the 1,400 - 1,420 price range. It is
not mere coincidence that the Volume by Price indicator is illustrating the
most trading volume having occurred in and around that price range. So what
does the recent action mean in light of the supposedly pending fiscal
calamity?
Everyone that is looking for
this monster move when the announcement is finally made may be waiting for a
while. It is without question that the broader marketplace is clearly aware
of the fiscal cliff. It would make sense that Mr. Market may have priced in
some of the uncertainty. Furthermore, if there was significant concern we
would be seeing prices starting to sell off by now.
Markets do not like
uncertainty. However, what is certain is that during the end of the year the
bulls usually have the upper hand. The reasons are fairly simple, but they
usually hold sway most years. Due to the holiday season, many traders take vacations
and leave their trading desks. Because traders are largely absent, volume
levels start to decline as the holiday season approaches. Typically volume
levels do not normalize until January of the new year.
Low volume levels typically
synch up with low volatility levels. When those two forces align together the
bulls will almost always have the upper hand. Is it any wonder that this time
of year the financial media begins discussing a "Santa Claus
rally"? Of course not, but Santa Claus is really just light volume
levels and low volatility levels in this case.
Recently volatility has been
pretty choppy, but the Volatility Index is not showing considerable fear
regarding the fiscal cliff in the near term. In fact, the VIX is trading in
the middle of its recent range as shown below.
At first glance, this chart
does not appear to be warning us about fear at the moment. However, certain
aspects of the Volatility Index (VIX) are largely unknown to the retail
investor. The VIX is a guide for volatility in the present, but it does a
poor job of projecting future volatility. Simply looking at the VIX's current
price is not the appropriate way to gauge market volatility expectations in
the future..
The Volatility Term Structure
is a better way of understanding what the Volatility Index is saying about
the future. Wikipedia lists the following definition for volatility term
structure:
"Volatility term
structures list the relationship between implied volatilities and time to
expiration. The term structures provide another method for traders to gauge
cheap or expensive options."
The current Volatility Term
Structure chart is shown below courtesy of www.cboe.com:
As can be seen above, the
forward Volatility Term Structure indicates that volatility is expected to go
higher in the future. This is not all that uncommon, but I think what is more
important is the rate of change in the near term.
When we look at this chart,
the term structure indicates that Volatility levels roughly 4 months out
(March 2013) are nearly 13% higher than they are today. By June of 2013,
volatility's rate of change is well over 20% higher than it is today.
It is important to understand
that volatility does not necessarily mean risk. Volatility typically
increases when equity prices are falling, however volatility levels can rise
for a variety of reasons. Uncertainty about the outcome of an event like
hitting the debt ceiling could push volatility levels higher without sending
equity prices sharply lower. The point is the term structure just provides
clues as it is not the holy grail about looking in the future.
What the Volatility term structure
does tell us is that the marketplace expects a significant increase in
overall volatility in the next 3 - 6 months. What I think the Volatility Term
Structure is conveying presently is that decisions regarding the fiscal cliff
and the debt ceiling will impact market prices, However the real impact may
not be felt until later in the 1st or 2nd Quarters of 2013.
Most economists believe that
if we do go over the fiscal cliff and taxes go up for everyone that the U.S.
economy will be in recession within 6 - 9 months. Clearly as shown above, the
Volatility Term Structure likely agrees with the economists assessments and
the economic conditions in the next 6 to 7 months could possibly turn for the
worse.
All we can hope for is that
the politicians can compromise on a plan that will remove uncertainty from
the marketplace without compromising the economy. Something tells me that is
not likely to happen, but here is to hoping that I'm wrong!
Happy Trading!
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