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Trading  | December 3, 2018

Volatility is an investor's nightmare, but it can be the Garden of Eden for a nimble trader. Since early October, the bull market in equities has given way to a rocky road where optimism and pessimism change places each day sending the price of stocks higher and lower. Wider trading ranges have increased opportunities to make money trading on an intraday basis, but it has also made investment decisions for the medium and long-term a lot more challenging over the past eight weeks.

Companies are not having earnings problems these days, as most have surpassed analyst expectations when it comes to their quarterly profit reports. The impact of tax and regulatory reforms in the United States over the past two years have continued to bolster the bottom line for U.S. companies. However, trade issues with China, rising interest rates, and political uncertainty after the midterm elections have combined to derail the stock market from its bullish path. Sentiment is a powerful force, and these days there is a lot more uncertain sentiment in the markets then over past years.

In the most recent speed bump in the stock market began to rock the bullish boat in early October, and at the end of November, the same issues are causing nightmares for investors and a paradise for traders. The iPath S&P 500 VIX Short-Term Futures ETN product (VXX) is a highly liquid short-term trading instrument that has been an excellent tool during the current environment where stocks are up one day and down the next.

A rough road since October and then the Fed signals capitulation

After a period where stocks did nothing but rise to record highs, 2018 has been a year of volatility but small gains as of the close of business on November 30. The E-Mini S&P 500 futures contract closed 2017 at the 2668.25 level, and as of the end of November, the index was at 2739, a gain of 2.65%. The appreciation in the index has been a far cry from results in 2016 and 2017 when it rose by 9.7% and 19.5% respectively. Investors had become accustomed to watching their accounts swell each quarter, and that continued after a corrective move in equities in February of 2018. The E-Mini moved from a new high of 2878.50 in late January to a low of 2529 the next week in early February, a decline of over 12%. By late August, the S&P 500 was back making new highs, and the selloff at the beginning of the year lead to a rally that moved the market steadily higher from early April.

October is traditionally a tough time for the stock market. The Great Depression began with the 1929 stock market crash in October. In 1987, stocks tanked on Black Monday, October 19. In 2018, we did not have a stock market crash, but a correction that took the E-Mini from a peak at 2944.75 during the first week of the fateful month.

As the weekly chart highlights, the E-Mini dropped to a low at 2603 at the end of October which was a decline of 11.6%, slightly less than the sharp move to the downside at the start of the year. It took the market two weeks to drop in January and February, but in October it took twice the time. So far, stocks have followed a similar pattern. In February and March, the E-Mini worked its way back to around 100 points above the midpoint of the high and low before they fell to within 23 points of the low during the first week in April. At that point, stocks took off to the upside and did not look back until October.

Most recently, the E-Mini worked its way back to around 20 points above the midpoint of the October high and low and then fell to within 23 points of the low, the same differential as in April. The stock market would be a technician's dream if it were to explode to a new high from the current level. On Wednesday, November 28 in a speech before the Economic Club of New York the Chairman of the Fed lit a bullish fuse on stocks that could lead to a Santa Claus rally.

President Trump has been riding his appointee to the Fed hard over the past weeks and months calling rate hikes by the central bank "crazy" and go as far as saying he regrets appointing Powell to the job. Aside from the ire of the Commander-in-Chief, the bumpy stock market, concerns over the rising potential of an economic slowdown, and the ongoing trade dispute caused the Fed Chairman to back away from previous statements on November 28. Chairman Powell added downside volatility to the stock market when he said the Fed was far behind the curve when it comes to hiking rates given the rate of economic growth and level of unemployment.

However, in his speech last Wednesday, the head of the central bank said, "there is no present path on rates" and while rates are low by historical comparison, they are close to neutral. The Fed soothed a very jumpy stock market causing the dollar index to retreat from just under a new high and the stock market to rally. The DJIA rallied by 2.5% on Wednesday, and the S&P 500 and NASDAQ saw gains of 2.3% and 2.95% respectively following the speech.

The weekly chart shows that the stock market has been extremely jumpy since early October dropping seven out of the last ten weeks. While the Fed Chairman backed away from his hawkish position in past speeches, the fact remains that the path of least resistance for interest rates is higher. The short-term monetary policy moves of hiking the Fed Funds rate is only a small part of the reason.

Rising rates are bearish for stocks

Even if the Fed softens its approach to rate hikes at the December meeting after moving the Fed Funds rate another 25 basis points higher, the impact of the program the central bank put in place starting in October 2017 will continue to keep upward pressure on rates. The legacy of quantitative easing is rolling off the Fed's swollen balance sheet at a rate of $50 billion per month putting pressure on medium and long-term government debt securities in the United States. There is no historical data about the impact of this program. Like QE, the effects of QT are unprecedented. However, stocks compete with bonds for capital flows, and there is plenty of data that tells us that rising interest rates weigh on the value of the stock market. As fixed income instruments offer investors higher yields, money flows from the stock to the bond market.

Statements from the Fed chief and a more gradual and less hawkish approach to monetary policy is likely to support a jumpy stock market in the short-term and could even cause a significant end of year rally. However, remember the words of JP Morgan Chairman and CEO Jamie Dimon from earlier this year who said that "one of the biggest risks to the U.S. economy is the reversal of the extraordinary measures central banks took to avert disaster after the financial crisis." The rote program has a lot more to do with the current turbulence in the stock market than a few 25-basis point short-term rate hikes. QE lifted the economy out of a situation where the U.S. faced a deep and dark recession, or worse. There is no data on what the unwind will do to the economy.

As the markets face an unprecedented QT program, it is also dealing with a trade dispute with China that threatens global economic growth.

Trade issues with China threaten the global economy

Going into the widely anticipated G-20 meeting that started on Thursday, November 29 and concluded with a dinner meeting between Presidents Trump and Xi, sharp rhetoric and moments of optimism peppered the news cycle. The uncertainty created a volatile cocktail for the jump stock market.

In the spring, the U.S. rolled out tariffs on China and other trading partners around the world. The move has been a negotiating tactic to level the playing field in international trade and create what President Trump seeks, which is "fairness and reciprocity" in trade. The President's criticism of China is nothing new as he continually pointed his finger at the Chinese on the campaign trail and throughout his Presidency. Going into the meeting, both sides have been positioning. President Trump continuously tells the press that he has the utmost respect for President Xi who he calls a "friend" but is prepared to slap tariffs on all Chinese goods coming into the United States if there is no progress at the dinner on Saturday.

The Chinese economy has suffered more than the U.S. economy since the protectionist wave began earlier this year as China sends more goods to the U.S. However, rare earth metals and U.S. debt could become tools for the Chinese if the dispute escalates and turns into a prolonged trade war. With the President sensitive to rising interest rates and China as the largest holder of U.S. government debt security, China has more than a few tools at their disposal aside from duties on U.S. goods.

Moreover, China controls almost all of the world's supplies of rare earth metals which are critical components in electronics and many other technological products including those with medical and military applications. The trade issues and uncertainty over the dinner meeting on Saturday have added to the volatility in the stock market since the beginning of October.

Gridlock in Washington may not be so bullish this time

The midterm elections in the United States put the House of Representatives in the hands of the opposition party in the United States which remains divided along political lines. During his first two years in office, President Trump enjoyed majorities in both the House and the Senate which allowed him to push through legislation for tax and regulatory reforms which fueled corporate profits leading to stocks market gains.

In the past, gridlock in Washington, D.C., has been good for the stock market. However, in the past, the Democrats and Republicans found common ground on the most significant issues facing the nation. In the current environment, it is likely that gridlock will put an end to many of the administration's growth initiatives and could even lead to a challenge to the President's continued presence in the Oval Office if the report from the special prosecutor arms the Democrats with enough ammunition to begin impeachment proceedings. Moreover, the most contentious Presidential election in 2016 will give way to an even more heated contest in 2020 when President Trump seeks another term in office. Gridlock in Washington may have been bullish for stocks in the past, but times are different in the current environment and stocks could find it very difficult to maintain the same level of optimism that has pushed them higher over the past years.

VIXX on any dips

I believe that the current level of volatility in the stock market will continue long into 2019.

The VIX is an index that measures the implied volatility of put and call options on S&P 500 stocks. The volatility index tends to act as a put option as it increases in value during periods of selling in the stock market. Market participants typically seek price insurance when the stock market moves to the downside causing option premiums to expand and the VIX to rally. Since the beginning of 2018, the VIX has traded in a range from a low of 8.92 at the start of January to a high of 50.30 in early February. The index dropped to lows of 10.17 in August and then moved higher to 28.84 in early October. The VIX has not traded below the 10 level mid-January and has been above 15 since October 8. In November, the index traded in a range from 16.09 to 23.81. Buying the VIX on dips has been the optimal approach to the stock market in 2018. The iPath S&P 500 VIX Short-Term Futures ETN product (VXX) is a short-term trading instrument that can turbocharge earnings during this volatile period in the stock market. The fund summary for VXX states:

The investment seeks to provide investors with exposure to the S&P 500 VIX Short-Term Futures™ Index Total Return. The S&P 500 VIX Short-Term Futures™ Index Total Return (the "index") is designed to provide access to equity market volatility through CBOE Volatility Index® futures. The index offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500® at various points along the volatility forward curve.

VXX is a highly liquid trading tool with $986.98 million in net assets and an average daily trading volume of over 48 million shares. The E-Mini futures contract dropped from 2818 on November 8 to a low of 2626 on November 23, a decline of 6.8%.

Over the same period, VXX moved from $28.48 to $38.58, a rise of over 25%. VXX acts as a short-term put option on the S&P 500, but like all options, the product suffers from time decay which is the price for the short-term leverage it affords in the market. VXX is not appropriate for medium or long-term positions, and I rarely hold the product for periods of over two weeks. On November 29 VXX was trading at the $36.48 level, but the all-time high is at $122,800 per share as the tool is subject to periodic reverse splits that destroy any value for long-term holders.

The VXX can be profitable dynamite on a short-term basis when it comes to taking advantage of short-term selling in the stock market. However, it will quickly become a dust collector for those who overstay their welcome in positions in the product. Taking profits when they are on the table in the VXX products is imperative.

A continuation of a jumpy stock market through the final weeks of 2018 and into 2019 means that buying VXX on dips to position for the next selloff could continue to be the optimal approach to the stock market over the coming weeks and months.

The Hecht Commodity Report is one of the most comprehensive commodities reports available today from the #2 ranked author in both commodities and precious metals. My weekly report covers the market movements of 20 different commodities and provides bullish, bearish and neutral calls; directional trading recommendations, and actionable ideas for traders. More than 120 subscribers are deriving real value from the Hecht Commodity Report.

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