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I was speaking with a well-respected leader in the financial community discussing the market. She made an astute observation; “We can deal with bad news and we can deal with good news, what we can’t deal with is uncertainty!” She is absolutely correct. One can position their investments for both good and bad economic and market conditions, but how does one prepare for uncertainty? I look forward to attending her Consultiva Symposium next week and hearing more about managing positions in uncertain market conditions.


The unfortunate driver of uncertainty, which is translating into market volatility is the Federal Reserve. We have become so reliant on Fed interventionism of QE, ZIRP, and a host of easy monetary policies, that we have forgotten to stand on our own two feet. When the Fed raised rates for the first time in almost 10 years, while only 25 bps, it shook the world markets.

It set a precedent that the Fed was now going to start raising rates at each Fed meeting. Some thought as many as 4 to 6 rate hikes were coming. Investors started unwinding their bond positions and those with margin (leverage or using a carry-trade) started unwinding their equity positions. They were trying to exit before everyone else.

The lack of buyers on the eve of a Fed rate hike parade, combined with sellers sent the market lower. The quicker the market dropped exacerbated the selling, as margin calls came due. My sources told me there were some significant margin calls liquidating positions. Of course this only fuels more selling, FORCED selling, which can easily feed on itself.

In both strong rallies fueled by “short-covering” as well as sell-offs fueled by “margin-calls”, the markets can quickly reach short-term extremes in which we see rubber-banding effects, bounces, “dead-cat” bounces, and gapping markets.

This surging order flow into and out of equities needs time to settle, consolidation will come.

Bringing Certainty!

What could put a floor into this market is if the Fed pauses with their rate hikes and perhaps takes on a more dovish tone. The market has been sitting on the edge of its seat listening to Yellen’s testimony, reading the “Fed minutes”, and listening to other Fed governors and presidents as to what will the Fed do next.

Recently the topic of NIRP (Negative Interest Rate Policy) has come up. Japan recently went down this rather extreme policy road already and it has been discussed at the Federal Reserve. Some Congressional members question whether it was even legal.

What the market read into NIRP, combined with the concern about a potential economic recession (if we are not already in one) and the weakness coming out of China, Europe, and Japan, is there is a high probability that the Fed might pause in raising rates and may even consider changing course.

It was this perception that has halted the slide in the equity markets for now and has brought about, perhaps, some slight bit of certainty. How can the Fed continue to take a hawkish position and raise rates if we could be facing a slow-down or worse a recession?

The markets even started to bounce off their lows the more Yellen and her comrades at the Fed began toning down their Hawkish talk and started discussing NIRP. Perhaps this was all staging, marketing and spin. Perhaps the Fed wants to CALM the markets without taking any action, by just dropping the hint of NIRP. One must admit if that were true it is a brilliant piece of marketing, because it did bring a pause and even a bounce to the equity markets.

Talk is Cheap!

Yet talk is cheap, eventually you have the pull-the-trigger and change monetary policy (raise or lower rates, ramp up QE, etc.). I have a saying, which I have often repeated;

“You can choose to ignore the math, but in the end you can’t avoid it.”

The Fed is currently ignoring the math; you know my feelings on the big three government headline data points. They have spun the fact that QE is over, yet by their own admission in their FOMC statement they continue to purchase government bonds and mortgage back securities. Did not the Fed define QE as buying bonds and MBS to Congress? It seems QE has ended in name only.

From January FOMC statement:
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

Real Risk Factor

What few are mentioning and thus ignoring the math, is the $4+ trillion in M2 supply sitting behind the dam as the M2 velocity has slowed to a trickle. That is an inflation bomb of epic proportions if that dam ever breaks and we see a ramp-up in the M2 velocity. I believe this is the single largest risk to the dollar and potential economic growth of both the US and perhaps world economies. Unless they can reel-in the massive supply and keep velocity from ramping, this thing could rear its ugly head very quickly.

I am often asked, “When is this high (hyper) inflation you are so concerned about going to happen?” I can’t answer when, I can only point to the math; the M2 supply dam, the M2 velocity decline, the largest buyer and holder of Treasuries, Fed balance sheet, and deficits to pay interest on existing debt. At some point you can’t keep printing and monetizing, thus expanding your debt, you have to pay it down or take a haircut or eventually watch it implode.

Probable, not Impossible

Now I am not predicting hyper-inflation or a particular date that it will happen. What I am saying, if one takes an objective view and looks at the math, the probability is extremely high that it will happen if we remain the course and are not careful to deal with it. I am not sure what the catalyst that could bring this on is; perhaps oil repriced out of dollars, perhaps China trade agreement repriced out of dollars to another currency, perhaps the BRIC bank gains enough EU members to become the new reserve, who knows.

Remember, while it maybe improbable, it is not impossible. Right now I am saying it IS PROBABLE and certainly very POSSIBLE.

Hawkish, Dovish, I don’t know?

In conclusion, the uncertainty we are living in today, which is driving market volatility is solely created by the Federal Reserve and their next step in monetary policy. Will it be Hawkish or Dovish? Right now it is unknown.

If the Fed continues on a Hawkish route, we will need to prepare for Flat to Bearish market for at least a year. If the Fed takes a Dovish route, we could see the market recover and begin to rally, unfortunately this means that debts will expand again. You would need to ask how much more time can NIRP buy you, perhaps out to 2017-2018. What’s after NIRP?

Yet today, the Fed is NOT Hawkish or Dovish, they remain ambiguous. And thus the market will continue to face volatility and rubber-banding action.

Support & Resistance

INDU 16,400
We had a good rally up into resistance levels and we remain in an uncertain time with the Fed. I would expect to see some selling and profit taking in here – as this is the previous high at the end of January. I would look at 16,000 as short-term support.

NDX 4200-4300
The tech heavy index has some room to run still, we could see some gapping moves in here as this is a very volatile index, especially intra-day. Expect resistance in the 4200-4300 range. I would look at support down at 4000.

SPX 1920-1940
We are back up into the resistance area from the end of January. Expect some selling pressure in here as investors take off their risk, either profit taking or minimizing losses. I would look at 1860 as short-term support in a sell-off.

RUT 1000-1020
The one index that is not showing the robust strength is the Russell. My decades of experience have me always following this index for simply general market order flow. This is the broadest index without the over-weights that can drive it higher or lower (like the Dow). It already looks like it has lost momentum the last couple of days and if we crack below 1000 we could be heading back towards 980.

(note: I use the Russell 2000 because it removes the over-weight stocks that make up the S&P, NDX, and Dow Jones. One can use the Russell 3000 which includes all of them, but it is amalgamation of the other indices.)

Option Position Traders Rejoice!

There is a small minority that does prosper in uncertainty, options traders. Uncertainty which can drive volatility creates opportunity for the option position traders. These are the times in which huge returns can be made. Of course you need to be on your game, have Gamma, and Vega. I remember during the Dot.com bubble burst, Asian Flu, 2008-2010 and other times, being long Gamma and what is commonly referred to as “Back Spread” paid huge dividends.

Of course this is a niche trading arena and this type of trading weights and measures Vega and potential volatility. It cares not what the underlying stock is, does, EPS, fundamentals or anything. It is simply looking for action – up or down. As long as there is action there is money to be made.

However, options are not just for option position traders. These are the times (at least since last November) that one should be hedging their long portfolio against market risk (volatility). Those that did, did not lose that much and perhaps even profited.

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