Traders have had a torrid time in the past month with global markets destroying 4.5 trillion dollars worth of equity value in that time.
In the article on Profiting With The Bears we highlighted the cyclical nature of the stock market and how the Aussie market typically pulls back in May and has declined between 14% and19% around this time in the past few years. Well, we have witnessed the first leg of this pullback, with the ASX down 9.5% since its April peak.
We have had a volatile start to trading in June this year. We began the month with severe selling, but in recent days we have seen a relief rally, as traders begin to hunt for some bargains on the hope that we may see a coordinated move by central banks towards quantitative easing.
Trading in June
June is typically a tough month for Australian investors and this year will likely see this theme recurring. Some of the reasons for this seasonally weak period include:
• Investors are recovering from the May sell-off
• Commodity prices typically ease into the new financial year
• Investors look to clean out their portfolios, selling underperforming stocks
• Tax loss selling
• Stimulus from the May Federal Budget often begins in the new financial year
This year investors have the added worries from overseas, and these additional global risks that are driving markets near-term:
• Globally investors are trading in a “Risk-off” environment
• Commodity prices have pulled back severely from their YTD highs
• Problems with a possible disorderly default by Greece, exasperated by their inability to form a new government. The next election is June 17.
• Spain is in the unenviable position of having to recapitalise its banking system at a time when they are having troubles accessing the capital markets.
• The euro zone PIIGS economies are having problems convincing their populations of the merits of the austerity programs they are implementing.
• US growth is slowing and the unemployment rate remains at stubbornly high levels.
• Chinese growth is slowing.
In times of uncertainty emotions drive the actions of investors. Traders in the US have recognised this and have devised a measure for fear, called the Volatility Index (VIX).
The Volatility Index, or fear gauge, has proven reliable in the past. The VIX is the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. It is a measure of the market’s expectation of volatility over the next 30-day period. Historically the VIX hits its highest levels during times of financial turmoil and investor fear. As markets recover and investor fear subsides, VIX levels tend to drop.
As stated in the CBOE Volatility Index white paper: VIX is based on real-time option prices, which reflect investors’ consensus view of future expected stock market volatility. Historically, during periods of financial stress, which are often accompanied by steep market declines, option prices – and VIX – tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline. It is important to note, however, that past performance does not necessarily indicate future results.
This effect can be seen in the VIX behaviour isolated during the GFC Debt Crises in 2008. As the chart below illustrates, the VIX spiked to its peaks as the market suffered through steep declines in mid-2008, and then rallied in early 2009.
Measuring the Fear
The VIX gauge is now moving to elevated levels, which is understandable as the VIX measures market expectations of near term volatility conveyed by stock index option prices. If history repeats then we may well be in a period of continued selling.
As seen in the chart, investors can use the VIX to define their trading strategies according to the underlying mood of the market.
The key levels on the VIX that traders need to be wary of are the 20 and the 40 levels.
As illustrated, when the VIX trades from below 20 and then crosses above 20 it is a time when “risk-off” should prevail. Traders should be looking to protect their portfolios, and look to profit by trading the market short, with the expectation that the volatility is likely to increase near-term (refer to the red dots on the chart). You can see from the chart that we are currently negotiating this type of market.
As illustrated, when the VIX trades down from above 40, it is a signal for more aggressive traders to look at the market for signs of capitulation.
More conservative investors will wait for the VIX to then cross below 30, for confirmation that the market environment is turning to “risk-on”. Traders should then be looking to build their portfolios, picking up bargains and trading the market to the long side, with the expectation that the volatility is likely to contract near-term (refer to the green dots on the chart). You can see from the chart that if history repeats then we are some way off from a bottom in the markets.
Central Bank Intervention
Central banks can short circuit market moves, and can provide the catalysts for a turnaround in sentiment.
In 2012 however, with the situation in Greece and the problems with the Spanish banking system, central banks in the euro zone are unlikely to move until at least July.
In China there is plenty of rhetoric about the government being supportive of the Chinese economy, as the domestic growth slows. China has just cut rates by 25 basis points for the first time since 2008.
In the US the Federal Reserve has indicated that it is not in a hurry to act to provide future stimulus, as Operation Twist is not due to finish until the end of June. The US growth rate is likely to remain between 2% and 2.5% in 2012, but there is the stubborn problem of a jobless recovery. If the Fed has its way it will be waiting for the EU and ECB to “fix” the debt concern issues in the eurozone.
Capitulation happens at market extremes and is often accompanied with an exhaustion gap and a huge spike in volume in the prevailing direction of the trend, as stock ownership passes from weaker hands to stronger hands. It will be interesting to see if this unfolds in our market, given the steady grind lower by the markets since late April. Trading volumes have been relatively low during in this market correction, but have been picking up over the last week.
We are evaluating the US markets as a proxy for our market, as the US has been resilient in the move to the upside in the past six months and we expect this leadership to continue for the foreseeable future, at least until the end of the year.
The VIX offers a unique insight into the psyche of the traders driving the market at this time.
We suggest a plan of action as follows:
• Bears are controlling the markets at this time, especially while the markets hold below their 50- and 200-day moving averages.
• Keep a defensive posture until the VIX confirms a turnaround in sentiment.
• “Sell the Rips” in the near-term.
• Look out for capitulation, where the buyers “give up” and step aside.
• Be wary of a turnaround if the market falls around -16% (as it has done in the past 3 years at this time of year).
• Re-evaluate if the market has consecutive closes above the 13-day moving average.
I trust that this information has been helpful. Contact me at D2MX Trading on 1300 610 024 and I can help you trade, using a number of strategies that will give you the tools to navigate this market and help you boost your returns on investment.
Investment Adviser D2MX Trading
This report was prepared by Michael Hevern. It represents the views and opinions of the author. It is not intended for use by any third party, without the approval of Michael Hevern. While this report is based on information from sources which are considered reliable, its accuracy and completeness cannot be guaranteed. Any opinions expressed reflect my judgment at this date and are subject to change. Contracting Hevern Pty Ltd is a Corporate Authorised Representative No. 408868 of D2MX Pty Limited ABN 98 113 959 596, AFSL No. 297950 (D2MX), and Michael Hevern has been appointed as an Authorised Representative of Contracting Hevern Pty Ltd. Opinions, conclusions and other information expressed in this report are not given or endorsed by D2MX, unless otherwise indicated. The information contained in this Report is General Advice only, as the information or advice given does not take into account your particular objectives, financial situation or needs.
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