What Financial Markets Are Telling Us: Low Volatility Signals Back and Forth and Forth and Back

Low volumes during the past week’s rally and the return to hedging via options mean the market is likely to soon break out to new highs before backing and filling again. The volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), while my technical reading of key stocks in the S&P 500 is bullish. Yesterday's cross-asset action brought one positive factor for US stocks. The US yield curve is bull steepening. Expect the S&P 500 to make marginal new highs and then be range-bound over the next few days.

Key to the action since October 14 (the past 5 days) has been the return to hedging (evidenced by the SKEW Index) among buy-and-hold investors who are not too confident in their bullishness. While this is often a negative sign of underconfidence, the bears haven’t been able to mount a shorting campaign and instead have been forced to cover their shorts. Volumes are so low that it’s key most investors are on the sidelines and that means a lot of backing and filling ahead.

The VIX has declined to nearly match actual volatility (measured on a 30-day basis) and that signals that the bears are close to giving in. The paradox of such a change is that there is no longer a bullish case for catching the bears out and forcing them to cover their shorts, since the bears have already done so and pushed the VIX lower. Combine this with low volumes and it’s clear the market is in neutral and will back and fill until some news pushes investors to act en masse.

The rise in bond yields and concurrent inflation expectations looks nearly done as short rates made a bottom on October 18 while long yields are inching higher to retest the past spring’s highs. This means lower volatility in interest rates and that will help keep markets even-keeled rather than volatile.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), Apple (AAPL), Johnson & Johnson (JNJ), 3M (MMM), Pfizer (PFE) and a small net short position in S&P 500 (the levered inverse ETF SPXU).