Cautious Approach to the Trading Markets as Volatility Looks to Increase

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Volatility Coming Back?
By Carley Garner
May 13, 2011

With the VIX hovering near multi-month (even year) lows, commodity prices under extreme volatility and the thinly traded summer months approaching, it appears that the environment is ripe for a large spike in volatility. It might or might not be immediate, but we feel as though a cautious (even more so than usual) approach to the markets will be imperative in the coming months.

An overnight bloodbath in the Euro and commodities triggered selling in stock index futures but as it turns out the bulls came ready to play. Thus far, they have been able to successfully defend support in the June S&P near 1330 but the fact that the market continues to test it leaves us siding with the bears in the short-term. Yesterday's highs in the major indices represented a 62% retracement of yesterday's sell-off and doesn't necessarily negative the bearish tone.

In addition, despite resilient price action, market sentiment has been damaged. After nearly two years of "easy money" in equities, the S&P has failed to make progress since early February. Historically this wouldn't be much of a game changer but in a market in which investors have become spoiled by steady gains and are now expecting them, nerves might begin to surface.

Another factor working in favor of the bulls is the comeback of the U.S. Dollar. It's true that a few days of rally doesn't make a new trend, but the charts point toward bottoming action. Even if the buck retests the lows, the lack of new lows should take some of the wind out of the bull's sails.

Yesterday's market rebound is being attributed to risk off trades, switching back to risk on...at least for now. It "feels" as though the commodity/Euro plunge might be coming to a conclusion, but we doubt the absolute lows are in. There could be margin calls yet to be satisfied. Assuming we are right about this and the Euro makes its way toward $1.40, gold to $1460ish and crude into the mid to low $90's again, Thursday's recovery in stock index futures could have been a dead-cat bounce and is to be sold.

A close below 1330 in the Jun S&P should open the door for prints just under 1300. If you are trading the Russell, look for support near 817 but if the S&P reaches our target, the 770's aren't out of the question. If the NASDAQ slides sharply, we could see as low as 2300.

From Wednesday's newsletter, but still valid:

With currency and commodity trade dominating the market, it seems valid to analyze the near-term outlook for markets such as gold and the Euro. A trusted source calculated the gold market sentiment a few weeks ago to be at 73.7%, meaning that 3 of every 4 traders were bullish. This is one of the highest readings in years and was a tell-tale sign of an overheated rally. However, now that the tides have turned, fickle gold bugs have also thrown in the towel. The sentiment reading now suggests that only 7% of traders are bullish. Is it time to buy? We aren't convinced that this is the turning point but it seems as though a dip to 1460ish could actually be the time to get bullish gold. Assuming stocks and commodities will continue to move in lockstep, our outlook on equities seems to fit right in.