Market Is Out for Revenge with the Return of Volatility and Extreme Headline Risk

I started writing this article last week, but new stuff came up so we delayed running it. Interestingly, the markets are becoming more headline risk driven. In fact, markets are acting like a proverbial cat on a hot tin roof – With every new step, the markets are likely to slide to new short-term lows or take a temporary leap in the air.

Last Wednesday morning’s hot mess was a good example of this: The central banks of India, New Zealand, and Thailand all dropped interest rates further than expected. This got the global bond markets jumping with prices going up and interest rates diving. Then, German industrial production numbers came in down -1.5% for the month versus an expected slide of -0.4% and the bond yields slid to near record lows in the U.S.

As I write this in the late morning on Tuesday, I’ve been on the set of Varney & Co. at Fox Business Network for almost two hours because of the tariff delay and reduction news that broke spiking the Dow Industrial average by over 500 points.

Volatility has spiked as the U.S./China trade and tariff tango added a new stanza and threw in the possibility of a currency war, as well.

With every new tweet and response, markets leap. Here’s some prospective on volatility using two measures: intraday price ranges (shown as Average True Range or ATR) and the CBOE Volatility Index or VIX:

For now, headline risk should keep this volatility at elevated levels, though likely not at the 60 S&P point level for too long…

Tom McClellan posted last Wednesday morning a chart of short-term interest showing the spread between the Rate of Change (ROC) in the price of the S&P and that of T-Bonds. It gives a short-term measure of how drastic the flight to quality is at any given time. Here’s Tom’s interesting chart:

McClellan notes:

“The current deeply negative reading is officially low, and in small company in terms of past extreme readings. All of the similarly extreme negative readings have been associated with important lows for the stock market.”

While this isn’t definitive that we’ve hit a bottom (nothing is definitive), it does give a good indication that the bond pop and S&P drop have it truly extreme levels relative to one another.

McClellan also points out a characteristic that this chart shares with the VIX indicator we looked at earlier – extreme reading in one direction (very high VIX & very low S&P vs. T-Bond ROC) have been historically predictive and tradeable. The opposite is not true. VIX can stay extremely low for long periods of time, and as we see in the chart above, the ROC spread tends to spike high at various points during a bull run.

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So, the transition from low volatility to high volatility markets means that we have to widen stops on new positions to give trades more room to run. And since this reduces our reward-to-risk ratio, it means that we have to be much more discriminating in trade selection until the volatility spike subsides.

The headline risk from the trade war with China has expanded to the possibility of a currency war as well. And it’s likely both sides will have more posturing statements and tweets that will send markets up or down with neck-snapping speed. We’ll continue buying pullbacks with the extra selectivity that I discussed above as long as the market stays above that key 2800 level on the S&P 500.

Great Trading and God bless you,

D. R.

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