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Will Bonds Be the Next Bubble to Burst?

Uneasy investors have been snapping up VIX calls at a rapid clip

by 8/6/2012 10:48:34 AM
Stocks quoted in this article:

The following is a reprint of the market commentary from the August edition of the Option Advisor, published on July 26. Prices and the chart are as of the close on July 26. For more information or to subscribe to the Option Advisor, click here.

"Markets tend to overdiscount the uncertainty related to identified risks. Conversely, markets tend to underdiscount risks that have not yet been expressly identified. Whenever the market is pointing at something and saying this is a risk to be concerned about, in my experience, most of the time, the risk ends up being not as bad as the market anticipated."
- Hedge Fund Market Wizards: How Winning Traders Win, by Jack Schwager

With the euro-zone debt crisis still simmering overseas, and traders in the U.S. looking anxiously ahead to the "fiscal cliff" looming at the end of the calendar year, investors continue to fear the worst for global financial markets. In fact, a couple of sentiment indicators we track recently revisited extreme levels not seen since March 2009 -- including the 10-week moving average of bullish investors in the weekly sentiment survey by the American Association of Individual Investors (AAII), which tumbled to a multi-year low. In other words, the current mood on Wall Street is more or less in line with that seen at one of the major panic bottoms in recent history.

Given this gloomy outlook, it's no surprise to find that bonds are still a popular trade with the "risk off" contingent. Bond funds have seen roughly $200 billion in inflows during the past 12 months, while domestic equity mutual funds have logged outflows of approximately $175 billion during this time frame. With the bond trade now looking very crowded, it's possible that we're on the cusp of a secular shift back into stocks -- particularly if the major equity benchmarks can extend their midsummer show of strength.

In addition to bonds, uneasy investors have also flocked to the CBOE Market Volatility Index (VIX) -- often referred to as the "fear index." The 20-day buy-to-open call/put volume ratio on the VIX is currently above 3.00, and these calls appear to be speculative bets on rising volatility. Considering this in context with the mass exodus from domestic equity funds over the past year, it appears that many traders are bracing for a spike in volatility and an all-out plunge in stock prices.

That widely expected VIX spike has yet to play out, though. The index peaked earlier this week at 21, roughly 50% above its March intraday and closing lows of 13.66 and 14.26, respectively. The 20-21 area has played a crucial role as both support and resistance during 2012, and this area currently appears to be holding strong as a technical ceiling.

 Daily Chart of VIX since January 2012

Turning to the S&P 500 Index (SPX), the broad-market bellwether has been testing support at the 1,333 level, which is double its March 2009 low. On the flip side, the SPX has encountered congestion near 1,370 -- a round-number area that marked a peak for the index in May 2011. The SPX has managed three daily closes above 1,370 so far in the month of July, which indicates resistance here may be weakening. If the index stages a convincing breakout above its recent highs in the 1,370 neighborhood, this development could convince a few sidelined investors to dip their toes back into equities.

In fact, short interest has already started to roll over from year-to-date highs, as the recent strength in stocks has proven to be an effective deterrent for some of the weaker bearish hands. With plenty of shorts left to shake loose, continued short-covering activity could provide a tailwind for the SPX.

While there are certainly real risks to consider for the global economy, it's important to remember the significance of sentiment analysis at times like this. No matter how bad the news is, it's the reaction to that news that drives the market's short-term direction. And with plenty of pessimism already baked into stocks, we continue to think there could be positive surprises in store through the remainder of the year.

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