DEFLATION--Are Markets Signaling The Dreaded Scenario?

Are the markets signaling DEFLATION ahead?  Japan is trying their high-risk experiment to inflate.  While their efforts seem to be working initially with the Yen collapsing and Japanese equity markets soaring, there is growing concern that their efforts would ultimately lead to failure.

I look at multiple markets, and I'm noticing a pattern that is eerily reflective of overall markets that is concerned about deflation ahead.  Gold prices plummeting is puzzling because usually precious metals perform well under periods of deflation.  We definitely need to keep an eye out for and be mindful of potential weakness in housing and real estate sector.  Strength in these sectors have been the foundation for prospects for improving US economy and reflation of assets prices.

Average Oil Futures Price Chart:  Oil prices plunging

JJC Chart: Copper Prices plunging

TLT Chart: Long-Term Bonds Rising

Corn Futures Chart:  Grain prices plunging

XLP Chart: Consumer Staples sector outperforming

XLV Chart:  Healthcare sector outperforming

Gold Futures Price Chart:  Gold prices plunging, but this is a
tricky one because gold prices usually outperforms in periods
of deflation

XHB Chart:  Definitely need to keep an eye on home

building sector because if US home prices start to fall, that

would signal really troubling times ahead.

IYR Price Chart:  The same goes for real estate sector.  Keep

an eye out for real estate sector weakness

VIX is Undervalued.

The S&P500 Index is moving into record highs and is showing very bullish action.  No way to say how high the equity market could go.  However, based on our proprietary volatility indicators, the momentum of realized volatility on the S&P500 Index is rising.  The S&P500 Index is also moving at a 13.55 realized volatility, while VIX currently is at 12.80.

The realized volatility indicator shows what an appropriate ATM IV of May options could be.  Since VIX on average has 12% premium over ATM IV levels, fair value of VIX should be around 15, regardless of whether the index is moving up or down.

The May VIX futures is trading now at 14.60, naturally at a premium over VIX, but 14% premium is also lower than the 18% premium on average, VIX futures trade with over 5-weeks to go before its expiration.

Executing a ratio call spread, selling the VXX May 19 call and buying 2x VXX May 21 call for under 0.40 debit wold be a good risk/reward strategy and gives you exposure to volatility over the next 2 weeks through big chunk of earnings season without too much risk.

New Paradigm

I'm going to present my thoughts that may be considered way out there...

Complexity theory took hold in economics in the 90s, especially the theory about increasing marginal value or utility(IMV), which turned conventional wisdom of decreasing marginal value upside down. In short, dominate (info, money, power, influence,etc) and set the standards and one could reap ever greater rewards.

This paradigm shift (IMV) and its ultra competitive underpinnings spread to every thread of the fabric of society at the micro level, which in turn set the unintended norm for the macro level--a vicious cycle not only acceptance of, but reverence for those that reaped the highest rewards without questioning whether or if any real value was created and/or how much of the social fabric was destroyed in the process. Societies' value (hence valuation) systems broke down.  In fact, this outcome is exactly what complexity theory models also predicted.

Since the near catastrophic end-game that was the financial/economic crisis of 2008-09, I believe another paradigm has been gaining traction in both the micro and macro levels--that is the theory of a holographic universe. Basically, everything is connected and everything is part of a greater whole. I'm not just pushing some new age, spiritual nonsense. I see it in every scientific discipline and research, in global economic and political policies, in the corporate world, in entertainment, etc.

I do not know what would be the end results of this new paradigm shift, but I have to believe it would be more positive and constructive then IMV.  I'm talking about 10-20 year bull market here... Yes, my outlook is far-fetched, but why not have a vision?

How does one monetize this vista?

Sell assets that have risen due to fear. That would be gold, long-term bonds, anytime VIX spikes. Buy portfolio of assets that are in the business of strengthening connections (human, corporate), perhaps GOOG(YouTube), FB, IACI(match.com), EBAY, media & content firms, crowd funding, etc.  Avoid firms that have traditionally try to profit from transferring costs to society, just to name a few off the top of my head... 


As a side note...ever wonder why "Gangnam Style", song and music video by PSY, a mid-30s, out-of-shape Korean rapper, shattered the record for the most watched You Tube video (over 1.3 BILLION+ views) and became a global phenomenon?  PSY said it himself.  His music, dance, and video focuses on participation and not exhibition.  They allow people to laugh and connect and be in the moment as the actors themselves.  This is completely different than entertainment from just a few years ago when people felt disconnected and perhaps even empty admiring or being envious of the so called "stars".

Options Market Tip 1-16-13

Quick Summary for 2013

http://www.youtube.com/watch?v=rPjVMUwkk2k

Video Shot 1/3/13

VIX Rising to 20.83 in the Next 2 Weeks?

 

As you can see in the chart of VIX above, the P&F Trend Indicator (from MetaStock) that I use for VIX turned positive once again as of VIX closing price of October 19, 2012.  I look at this indicator because it turns positive so infrequently when it comes to VIX.  Last time P&F Trend Indicator turned positive was on May 4, 2012.  At that time, I wrote a research piece titled "VIX Rising to 24.6 Before May VIX Settlement?" in my blog.  In fact, VIX rose from 19.16 on May 4th to 21.97 the last trading day of VIX May expiration.  VIX continued to rise as high as 25.1 over the subsequent few trading days.

The table below shows the instances when VIX was under 25 and P&F Trend Indicator turned positive over the past 12 years.

Unlike in my May 4th post, I added a calculation of averages excluding what I considered outliers (highlighted in green & yellow) to come up with average or expected Max % Gain & Max % Loss of VIX looking 10 trading days forward.  Based on the average numbers, VIX could be expected to rise as high as 20.83 or fall to as low as 16.04 over the next two weeks.  Furthermore, using these VIX ranges, VXX then could be expected to trade within 40.6 to the upside or 33.4 over the next two weeks.  VXX ranges are calculated (roughly) with assumptions about how it has moved in the past relative to VIX movements.

I understand that trying to calculate "Expected" or "Average" numbers with such few data samples is not quantitatively reliable.  Nevertheless, it is a worthwhile exercise to carry out when formulating a trading strategy based on scenarios of how VIX may be expected to move.  Perhaps, buying the VXX November 35/38 call spread could be a good trade.

Differences in Perception & Reality: Time to Go Long Volatility

Back in late August and early September, and ahead of ECB announcement, S&P500 Index experienced a period consolidation.  As you can see in the first blue oval, the market went sideways, then took off after  Draghi's announcement of Outright Monetary Transactions (OTM) policy.  Over the past two weeks, the market has also undergone a consolidation of sort.

The interesting difference between these two periods of consolidation is VIX (shown in plum) movements and my Fair Volatility Estimate or FVE Indicator (shown in blue).  As you can see indicated by the red arrow, VIX steadily rose ahead of the ECB announcement to 18 level, while FVE remained low and in a declining trend.  After the ECB announcement, VIX plunged.

Recently, however, FVE has been steadily rising, yet VIX has remained mostly below FVE Indicator's values during this consolidation and also below its values during the previous consolidation.

The reality is that the current ongoing consolidation of the S&P500 Index is showing greater volatility, yet market volatility perception as measured by VIX is not quite reflecting this.  I believe presents a good expected payoff scenario in favor of going long volatility.