VIX Fear Reading, Political Gridlock Mean Investors Should Tread Lightly

The markets continue to make it difficult for those of us that are looking for longer than a day trade, especially with the VIX reading above 30. The VIX has been above 25, and for the most part between 30 and 48, for every day since the August debt ceiling debate and the growing crisis in Europe. At these levels if you are involved in the markets you need to reduce your position size in order to allow a larger than usual breathing room in terms to stop losses.

For the most part it feels like we have been running a marathon on a trend mill – running in place, using plenty of energy, and not getting anywhere. We have had some of the largest back and forth swings that have not resulted in either a complete break to the upside or downside in the major markets. YTD the S&P is down-3.42% and the Dow Jones is up +1.77%.

For the most part the markets and even sectors have tended to correlated in major swings with the S&P, yet some sectors have done better than others. What is worth noting is that some of the stronger sectors from a few months ago, like semiconductors (SMH), have not held up in this last market downtrend.

Another point to note is that the two sectors that did better than the S&P over the last month (last 20 trading days) are the same two sectors that are doing well in the last 52 weeks, Consumer Staples (XLP) and Health Care (XLV). On the flip side the two worst performers in the last month, Financials (XLF) and Metal & Mining (XME), have also been the worst performers for the last 52 weeks. This once again confirms that you keep and add to the strong names, and drop the weaker names.

If we look at the performance of some ETF representing global markets or commodities you can get an idea as to how the bigger asset allocation has been moving around. Europe (EWG) and Emerging Markets (EEM and FXI) have been hit the hardest for the month as well as in the last 52 weeks. On the other US Treasuries (LTL) and the $ index (UUP) have outperformed this month. Interesting to note that US treasuries and dividend plays(SDY) are the two ETF that are closest to their 52 week high, indicating they have held up very well and are a safe haven for market participants so far in the last 52 weeks.

Going forward it seems like we are in the hands of politicians both in Europe as well as here in the US.

The economy has been going through a massive de-leveraging over the last few years – companies have de-leveraged (and now have stronger balance sheets), households continue to de-leveraged (less personal debt and mortgages either through personal choice or because they have been force to sell assets to pay down debt), and now governments are forced to de-leverage as well (we have seen this in the past in developing economies, but never to such a large extent in developed countries). The only entities that are inflating their balance sheets are the central banks, FED ECB, as well the IMF and other institutions – for how long (or how much) they can do this is anybody’s guess.

Companies and now households have dealt with the deleveraging in what seems to be in a positive way – for sure companies’ balance sheets are better than they had been. As for households this has been more painful as houses have been foreclosed on and jobs have been lost, nonetheless a deleveraging is occurring and that will build a stronger foundation for when employment recovers.

The missing piece for now is the governments, which seem to have rules of their own – mainly because they control the two sides of the equation (spending and taxation) – corporations and individuals don’t have that control. The result of this is inaction, or plainly “kicking the bucket down the road,” unfortunately this time around this is impacting the shaky recovery we had started to see in the US economy. The idea that “elections” will solve this issue is just another way to do nothing – I’m no political expert but in my opinion after the election in 2012 is that we will still have a divided political system in the US – as some of my friends like to say “same same but different” – so what is the impact of this waiting period on longer term investment decisions?

Bottom line as the VIX and the performance of sector ETF is telling us to enter positions with less size, so we can continue to wait until the edge is back in the favor of the longer term players. We will continue to do work on the fundamentals of companies as well as pricing these ideas, since we need to be prepared with a shopping list for when the VIX settles down. For now be content in doing your homework, and enter with smaller size.

By Mario Carias

Disclosures: No relevant positions

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