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What Should Investors Know About Volatility, As We Approach The Year End?

Summary Volatility is a powerful tool that allows to profit from market sentiment. Seasonality data suggests volatility is set for more downside. U.S. economic data will take a center stage for the remainder of the year, but unexpected developments overseas may bring about more volatility. The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is fear of the unknown. H. P. Lovecraft The wounds are still fresh. The last couple of months were tragic for global capital markets. It was all about the turmoil in equities, caused by global economic uncertainty, slowdown in China, and the Fed’s indecisiveness to raise interest rates due to inflationary and employment concerns. This has pushed the U.S. and global capital markets into correction territory, the second worldwide decline in less than a year. The markets bottomed on August 23rd, and reversed in ironic fashion, climbing back up to the pre-correction levels of mid-August. As of November 3rd, the U.S. major indices were mostly flat for the year. Following the action in the equity markets, CBOE’s Volatility index , or VIX, advanced rapidly, as investors rushed out of their positions. The Volatility Index (VIX), often referred to as the gauge of fear, has gained 140% over the course of one week, following the dovish announcement from the Federal Reserve to keep interest rates unchanged at the FOMC meeting on August 19. VIX, of course, has a negative correlation with the S&P 500 index, which lost close to 10% during the same period of time. (click to enlarge) As markets reversed their trend, so did the VIX. It declined steeply to the lows of early August, to indicate the rising confidence of market participants. Investors who have not watched the markets closely during that period of time might have spared themselves some sleepless nights. For some people however, the global turmoil and rising uncertainty in the stock market had equally presented an incredible opportunity to profit, by investing around wild swings in volatility. With the correction behind us, I’d like to give my projection for the VIX, as we now entered the last two months of the trading season. Short-term volatility outlook. Following the recovery in equity markets, volatility has declined more than 70% from it’s peak on August 23rd. While that is undoubtedly a significant move to the downside, I believe that the VIX has yet to hit its bottom. Below are several factors that are set to weight heavily on VIX performance going forward. Seasonality It is no secret that the behavior of certain investment instruments differ throughout the year or from one stage to another within the economic cycle. Constantly recurring seasonal events fundamentally affect the performance of individual stocks, indices, and overall markets. Many traders look out for these patterns on the chart to determine the momentum of the instrument in question. Volatility is one of those affected by the seasonality. (click to enlarge) If history holds any clue, both November and December comprise the period of declining volatility, that generally peaks in October, as per chart above, which indicates the average annual performance of the VIX over the last 20 year period, ending 12/31/2014. Interestingly enough, the Volatility Index behaved astonishingly similar in 2015. And although certain skepticism still prevails in the market, it is unlikely we see another correction any time soon, that might propel volatility higher. In fact, investors should now feel more confident, after tackling a pullback in equities, believed by many to be overdue. Specificities . December is certainly the month to watch, as both year-end portfolio rebalances and more surprises from the Fed may cause investors to become uncertain. The U.S. economic data will take center stage during the last two months of the year, as non-farm payrolls for October and November will be dissected for clues in regards to the timing of the initial rate hike. As futures indicated a 50% chance of December rate hike as of November 3rd, I predict any negative number to add volatility to the market. The first GDP estimate for the third quarter was driving U.S. markets this past Thursday. Nevertheless, this figure will be subjected to further revisions in November and December, and will not cause much volatility, as market participants have already priced in the increase of only 1.5% for the quarter. More stimulus from China and Japan, as well as positive remarks from ECB’s Mario Draghi on situation in Europe, will definitely propel markets higher. China, on the other hand, still poises the biggest threat for global capital markets stability. An additional slew of worse-than-expected data from Beijing will likely trigger GDP downgrades, that will re-ignite the fear of global slowdown. Lastly, expect the end of the year trading activity to be light. The holiday season is likely to keep investors on the sidelines until the new year sets in. This does not necessarily mean a quiet period for the markets. Investors should follow the news closely, as illiquid exchanges are less likely to absorb selling pressure caused by global developments. The ways to use volatility to your advantage Every investor who would like to trade around market sentiment might want to consider gaining an exposure to the CBOE’s Volatility Index (VIX). Although it’s impossible to purchase VIX directly, there are ways to gain such exposure either through options, or by taking a position in one of the designated ETFs. Volatility as an investment vehicle has unquestionably gained in popularity among investors. Almost every ETF provider now issues products that are linked to the volatility of a broader market. These products vary substantially in terms of leverage, liquidity, and underlying assets, but they all try to replicate either a long or short position in the Volatility Index. VIX currently trades at $14, which implies roughly 15% downside, if traded against its long term support. One of the ways to speculate on that is by shorting the Barclays S&P 500 VIX Short Term Futures ETF (NYSEARCA: VXX ), that re-invests in volatility futures on a rolling basis. From my observations, VXX incorporates 30% to 70% movement of the VIX during short periods, suggesting 5% to 15% move to the downside, excluding contango drag down. For investors who might want to gain a leveraged exposure to the VIX, the VelocityShares Daily 2x VIX Short Term ETN (NASDAQ: TVIX ) would be the second best instrument to short. It currently trades for $5.85, or more than 15% above it’s pre-correction levels. In addition to that, the current state of contango is expected to weigh heavily on volatility ETFs if shorted for an extended period of time, suggesting even more downside. Risk-reward, however, is not as attractive as it was a month ago. After falling significantly from its peak, volatility still preserves enough momentum to justify an ongoing decline. However, investors now face far greater risk associated with the strategy, and should be aware of any potential loss related to it. Despite my bearish volatility outlook, I generally seek better risk-reward potential to initiate a position. Preserving the money in this case is far greater concern. Nevertheless, any small speculative bet at this point is definitely warranted. I urge market participants to be more cautious when putting money to work at this time of the year. Best of luck to all investors!

GLD: The Hurdles Still Remain

Summary We continue to have several things working against the gold sector at the moment. I have been selling more over the last week as this rally looked to be petering out somewhat, but I still have positions established in several gold and silver companies. If gold goes under $1,000 per ounce, then it will probably be the last time you will be able to buy it at that price ever again. The bearish hurdles that I talked about a few weeks ago in my last article on the SPDR Gold Trust ETF (NYSEARCA: GLD ) are still in place. In fact, they have become even larger since that time. We continue to have several things working against the sector at the moment. Those include the divergence between GLD and the gold stocks (HUI and XAU), the long-term downtrend that is still in place, tax loss selling into the year-end, and possible interest rate hikes at the December Fed meeting. The gold sector needs to overcome these before you can even start to talk about a new bull market. The latest sell-off in the precious metal sector began in early June, and since that time GLD has almost gotten back to even while the HUI is still showing a sizable loss. There have been many instances in the past when you suddenly get big divergences that occur in terms of where GLD/gold is priced at in relation to where the gold stocks are trading, and they usually don’t last long. At one point this month, the HUI was down about 35% while GLD was only down about 2.5%. That performance gap was extreme and it simply wasn’t going to be able to continue. Since that time, the HUI has outperformed, but it’s still lagging the price of gold by a fairly large margin. One of them is right though, and one of them is wrong. Either GLD reverses hard over the short-term, or the HUI makes some substantial gains during that time. ^HUI data by YCharts Given the price action in the HUI since the Fed meeting, one could argue that it’s the gold stocks that are correct. But it’s too soon to determine if this rally since the August lows is just a bear market bounce. Technically, the gold stocks appear to be breaking down, but I don’t like to rely on events that happen immediately after a Fed meeting, as the initial move isn’t always the correct one. Without question though, the long-term trend is still down. If the HUI can’t make a charge higher over the next several weeks, then investors will most likely start taking some tax losses in these gold stocks (if they haven’t already), as many have dropped substantially since the beginning of 2015. This will further fan the flames and we could get some major declines into the end of the year. I showed the YTD percentage loss for the following stocks in my previous article. Over the last few weeks, they have decreased even more, and the chart below reflects their current losses year to date. GG data by YCharts We also have the Fed and interest rates weighing on the gold market. Last time, I talked about how the Fed has been consistent with its message since 2012, in that the majority of members have been signaling for the last three years that they believe 2015 is when the first rate hike will occur. My argument remains that the Fed is going to lose credibility if it doesn’t raise rates this year. The weak jobs data in September had everybody believing that the Fed was on hold for the rest of 2015 and maybe well into 2016. As I said in my last update: I believe that rate hikes are still on the table, and this should be clear at the conclusion of the next Fed meeting in a few weeks. If this occurs, then gold could come under pressure again. Given the following statement out of the Federal Reserve, a 25 basis point increase at the December meeting is still a high probability event: In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. Translation: baring a major decline in the U.S. and global stock markets between now and the end of the year, and assuming economic data doesn’t collapse, the Fed is most likely going to raise rates at the December meeting. GLD and the HUI could remain under pressure over the remainder of 2015, but I continue to believe this will be a “sell the rumor, buy the news” event, and gold will finally bottom soon after the first rate hike. It might not happen right away though, as there could be a slight lag. Contrary to popular belief, gold doesn’t perform poorly when rates increase. The last time the Fed embarked on a rate hike program was in 2004-2006, as the Fed Funds rate went from 1.00% to 5.25%. Gold went from just under $400 to… well, take your pick on which date and price you want to use. Clearly there was a huge bull market in gold occurring at the time. (SOURCE: FRED ) If you go back the the 1970’s, it was the same situation. And notice in both charts how gold increases immediately (or almost immediately) with the Fed Funds rate. In the chart above, gold was up about 20% in the 4-6 months that followed the first rate increase. (SOURCE: FRED ) There is one additional hurdle that the gold sector is facing at the moment, and that is the recent strength in the U.S. stock market. Anybody that has read my previous articles on GLD knows that I’m bearish on the U.S. indices. While I don’t expect a major collapse to occur, I do believe we could see a multi-year bear market with a 25-35% decline, or at best a sideways trading pattern. Stocks need to digest the massive gains that have been racked up since 2011. In other words, it’s time for a breather. But November and December are always strong months for stocks, and it seems like they are trying to have one last hurrah before finally giving way. You can see how GLD and the S&P have been trading inverse to one another over the last few weeks. Should the stock market continue to hold up, then gold wouldn’t have that firm bid underneath it as money would still be chasing these highflyers. Only when we see the S&P roll over we will see gold start to take flight. ^SPX data by YCharts My Updated Plan Of Action On October 16, in the comments section in my previous article on GLD, I told readers that I had started booking some profits in a few precious metal stocks. The reasoning was many of these were hitting their 200 day moving averages, so I thought it might be prudent to lighten up a bit. I have been holding many of these stocks since the August lows, as that is when I jumped back in. Some positions were established on the morning of October 2, as GLD had a huge move to the upside. I thought it might be wise to take some gains and see what happened over the next few weeks. My plan was to buy these positions back only if a breakout was confirmed. (Source: StockCharts.com) I have been selling more over the last week as this rally looked to be petering out somewhat, but I still have positions established in several gold and silver companies. I’m just going to hold these and see what develops. I have no desire to buy anything at the moment given the recent weakness, I would need to see some positive price action in the HUI first. Right now 104 and 130 are the two levels I’m paying attention to. Below 104 and it’s time to get very bearish, above 130 and the rally could go further and possibly develop into a bull market. As long as the HUI remains in the middle of those, then I’m just going take a wait and see approach. My Strategy With Timing This Gold Bottom I want to talk a little more about my strategy when it comes to the gold market and why I was buying in early August, even though I still believed there was more downside over the next several months. To me, this all comes down to the math and probabilities, and buying at that time was a win-win scenario. I had two options: wait for a final capitulation and preserve 100% of my capital, or start to buy in and run the risk of losing some money. This is not about the amount invested, it’s about the percentages invested. The HUI peaked at 630 in 2011, in early August it was just above 100, or an 84% decline from peak to then-current trough. I know that the HUI isn’t going to zero, as no index has ever been wiped out completely. So the question is what could be left on the downside from the roughly 100 level. The Dow declined 90% during the Great Depression, a similar decrease in the HUI would take it to 63. That price target seemed to be a very real possibility. That would most likely result in a 50% haircut in the major gold stocks that make up the index. My thought process was to buy in 20% at the August lows, and see what transpired from that point. If I lost 50% on that capital invested as the HUI went to 63, but still had 80% cash on the sidelines, then I would gladly take that. For two reasons. One, being able to buy 80% in at 63 would be an incredible opportunity for some serious long-term gains. But even if the index declined further after I bought – to say 40 to 50 – didn’t matter so much. I know that the absolute lows during capitulation events don’t hold for long, and those losses that occur at the tail end are made up in just a matter of months. It only took a few months for the Dow to double off of the bottom, and a year later it had tripled from the lows. So if the HUI plummeted to 63 or lower, it would increase back to 100 in short order. I would also quickly gain back that money lost on the initial capital outlay in that scenario. Conversely, using 20% of my allotted capital to purchase gold and silver stocks at the August lows protected me from getting behind the eight-ball, if that turned out to be the absolute bottom. I’m always trying to stay ahead of the curve. And when I get ahead I want to keep pushing that envelope and increase my distance even further. Not taking advantage of this opportunity given would have been risking losing that positioning. Plus, if the bottom was established at that point, it would have meant I would have started to buy at the absolute lows. Worse case it would be a good trade as it was clear that these stocks were turning up in the short-term. So either scenario had a very positive outcome, which is why it was a win-win type of event. Let me be clear, this is only applicable to the current price environment of the gold stock sector or when trying to time the bottom of a sector that has already experienced a massive decline. The Last Time Gold Will Trade Under $1,000? Nothing really bullish has occurred yet in the gold sector. And with all of these hurdles that it faces between now and the end of the year, it opens the door for further downside. My ultimate target since the Fall of 2014 has been 90-100 in GLD, or roughly $950-$1,000 in gold. I still believe that if there is one more decline, that it’s most likely going closer to the 90/$950 target. If that occurs, then it will probably be the last time you will be able to buy gold under $1,000 per ounce ever again. Prices of all assets continually rise over time as the money supply increases. The fair value of gold is around $1,400 an ounce (my estimate given the growth in the money supply and just looking at the current cash cost environment). That’s not going to decrease as time progresses, it’s only going to increase as the consistent trajectory of M2 is higher, not lower. Gold is no different from other goods that are produced. It costs money to extract gold from the ground, and as the money supply increases, then so do those costs. Where those costs are at gives us a good idea of where gold should be trading. But all assets can trade well above or below fair value for a given period of time. Eventually though, the rubber band gets stretched too much (in either direction) and you get a reversion to the mean or an overshoot. Gold below $1,000 would be a stretch already at current money supply levels and growth rates. In 10-20 years, it would be impossible to have gold under $1,000, given the amount of inflation that would be introduced to the system during that time. Just like today it would be impossible to have gold under $300, which is where it was at 15 years ago. So if the price does get to under $1,000, enjoy it will it last, because it will most likely be the final time gold ever trades in the three digits. That just shows you how much upside potential this sector has.

Who Are The Market Makers? What Do They Do? WHY?

Summary We constantly talk about the market makers [MMs] and their activities. It is apparent from their comments, that many readers have varied, limited views about the function of MMs, their status, regulation, objectives, and their compensations. A late-August irregularity in securities markets functioning created knowledgeable analysis and comment discussing all that, much of which may help our perspective and understanding. The August 24 th Market Opening Problem The casual, intermittent user of US equities markets may not even be aware that there was a problem or the seriousness of its condition. By 10:30 am NYC time that Monday, things were pretty much back to near normal, and trading the rest of the day was being conducted about as usual. But the previous hour or two nearly shut down the ability of investors and speculators to carry out their planned transactions. Many unpublicized DK (don’t know) trades complicated the end of day settlement processes. Here is how one deeply involved observer firm described what happened: Recent Volatility in the US Equity Market In late August 2015, the US equity market experienced a rapid spike in volatility as global market sentiment weighed bearishly on stocks. During that period, the VIX volatility index doubled and equity-trading volumes surged as investors reassessed global growth prospects and inflation expectations. Market activity on August 24 was particularly extreme. Before the market opened, global equity markets were down 3% to 5% and the e-mini S&P 500 future was limit down 5% in pre-market trading before wider price curbs went into effect at 9:30 am. Due to these pre-opening factors, the morning began under selling pressure with substantial order imbalances at the open as investors reacting to global macro concerns flooded the marketplace with aggressive orders to sell (that is, orders to sell without any restrictions as to price or time frame such as market and stop-loss sell orders). According to the New York Stock Exchange (NYSE), the volume of market orders on August 24 was four times the number of market orders observed on an average trading day. Extensive use of market and stop-loss orders overwhelmed the immediate supply of liquidity, leading to severe price gaps that triggered numerous LULD (limit-up, limit-down) trading halts. The confluence of these factors contributed to aberrant price swings and volatility across the US equity market. For example, the S&P 500 index was at a low, down 5.3%, within the first five minutes of trading, then rallied 4.7% off the lows before selling off again late in the session to close down 3.9%. Bellwether stocks such as JPMorgan (NYSE: JPM ), Ford (NYSE: F ), and General Electric (NYSE: GE ) saw temporary price declines in excess of 20%. Individual stocks as well as ETPs (exchange traded products) and CEFs (closed end funds) experienced significant dislocations after the opening followed by unusual volatility. Transparency and Information Flow Price transparency and information flow in the US equity market were curtailed from the start, forming one of the key contributors to the day’s events. Anticipating widespread volatility, NYSE invoked Rule 48 prior to the open. NYSE Rule 48 suspends the requirements to make indications regarding a stock’s opening price and to seek approval from exchange floor officials prior to opening a stock. By suspending time-consuming manual procedures, this action should have permitted Designated Market Makers (DMMs) to open stocks more quickly and effectively. However, this rule had the unintended effect of limiting pre-open pricing information in securities, especially for any stocks experiencing delayed opens. Although DMMs actively worked to facilitate a prompt open for all securities, the opening auction was considerably delayed for an extensive number of stocks. At 9:40 am, nearly half of NYSE-listed equities had yet to begin normal trading. These delays, along with the absence of pre-open indications, impeded the normal flow of information, which market makers and other participants rely upon to perform their customary activities with respect to the market open. Without this information, and with many securities experiencing delayed openings, correlations snapped between prices for securities in the same industry or ETPs tracking identical benchmarks deviating significantly from one another. In financials, for example, JPMorgan experienced a sharp decline, while Morgan Stanley (NYSE: MS ) did not. The basis between futures and cash prices for the S&P 500 index also widened considerably – futures traded at a 1.66% discount to the corresponding equity basket. These dislocations heightened uncertainty in the market because the validity of automated pricing models becomes challenged when there are meaningful disparities between the prices of normally correlated securities. Additionally, since many of the computerized processes, which support market making, rely on futures as a reference asset, the ability of market makers to efficiently allocate capital and price risk was inhibited. Market makers faced further uncertainty on the cancellation of potentially “erroneous trades,” adding to their reluctance to trade. The lack of price transparency impaired the ETP “arbitrage mechanism” because market makers were unable to rely upon price information for individual stocks to determine when arbitrage opportunities exist between the ETP and its underlying basket, and to hedge their positions. In the absence of the necessary data, many market makers ceased arbitraging US equity ETPs. Exchange-Traded Products The market forces discussed above led to a temporary breakdown in the arbitrage mechanism of many ETPs. 327 ETPs experienced LULD halts on August 24. Many ETPs also experienced brief periods where they traded at significant discounts to the value of their underlying portfolio holdings. As a result, the events of August 24 left many investors dissatisfied with the prices at which trades were executed and raised concerns about the functioning of markets and ETPs. Further, like individual stocks, the confluence of order imbalances, lack of information flow, and opening issues contributed to differing experiences, even for comparable ETPs. Retail investors who had standing stop-loss orders were especially impacted – once the stop price was reached, the orders were converted into market orders, which were often executed at prices that were markedly lower than the stop price. As stop-loss orders are typically intended to be used to mitigate losses, investor education about the risks of stop-loss orders should be significantly increased. To that end, Figure 1 may be helpful. Figure 1 (click to enlarge) Now You Probably Know More Than You Want And there is even more complexity involved. But the necessary message is that in a trillion dollar a day market complex, lots of actions need to be coordinated. Computer programs that expedite actions have rigidities that need to be softened in some circumstances by human judgment. Often that is where market makers [MMs] get involved. Several of the key MM functions and responsibilities are outlined in Figure 2 Figure 2 (click to enlarge) Source: BlackRock Capital Management Figure 3 identifies the principal roles of MMs as providers of liquidity, the usual MM function thought of when the subject of market makers comes up. Figure 3 (click to enlarge) Source: BlackRock Capital Management Key to understanding these roles are the impact they have on prices and price trends. The size of capital involved in typical transactions is a principal determinant. That makes the first listed category of Liquidity Provider, the block trade facilitating broker-dealer, the most significant stock price impactors of MMs by far. These are irregular but frequently occurring, multimillion-dollar trades. Each one typically has the price impact potential to step away from the posted last trade and the current bid~offer quote by a full percent or more. Skillful execution may prevent such a change, or encourage it. Trade and market savvy are important resources, along with arbitrage experience. Firms engaging in the block trade business are often vertically integrated or diversified in their MM activities into several other or all of the roles listed. Exchange-registered market makers tend to be the traffic cops of the current day exchange world and have procedural influence that affords stature in the internal community. Their exposure to the public is usually quite limited, but their day-in, day-out functions may be essential. The remains of the exchange floor specialist system are here. Wholesale MMs serving regional brokers are essentially an internal function of the MM community and are among the least influential as to procedure or securities prices. Technology dominates the electronic MMs, earning them frequency and pervasiveness of presence in number of trades. The billions of shares regularly traded could not be exchanged without this support. But the typical price changes involved from last trade tends to be tiny and highly mechanistic. Their principal contribution is immediacy of executions at low cost. The high-frequency arbitrageurs or HFT players are the intellectual and market savvy step-outs of the electronic MM organizations. Their influence is in the bid~offer realm more than in the trade volume arena. They are constantly sniffing quotes to find risk-free arb opportunities, and individual investors rarely are aware of their presence. But their reach is extensive and they are a liquidity-providing influence. Competition hones their honesty, as a group. Their accomplishments financially tend to be a basis point at a time, just a million times over. They are expert exploiters of the leverage of time. For those interested in the full complexities of the market making process here is the complete BlackRock discussion and their recommendations for market operating revisions. Some of the underlying problems go back to the 1987 “portfolio insurance” market failure debacle. Conclusion Market makers come in a variety of flavors and perform many functions essential to the power and value of today’s equity markets. Where their influence to the advantage of individual investors is the greatest is in their service to those investment organizations that must trade in market-disrupting units because of their size. That limitation of size is unavoidable since the economic basis for their investing businesses is in the amount of capital under their management. They are active investors in order to utilize their info-gathering intelligence resources. But the advantage for us is that they use the arbitrage skills of trusted market making firms to provide the other side of those big trades and the temporary financial liquidity to acquire or dispose of the thousands of shares regularly involved. In the process of MMs hedging the risk to their capital, what is revealed is the extent of the risk believed to be present. Those self-protective actions and the implicit price-range forecasts prove to be useful guides as to future specific price moves, on a very comparable base among equity investments of wide diversity.