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Volatility Suggests Caution Warranted

Published on March 5, 2013 by in Market Comments

We’ve shown this chart a couple of times over the past several weeks, but it continues to give warning as the market rallies higher. A short ETF for the S&P 500 Index (SH) is making new lows today as the S&P 500 Index (SPX) is breaking above its recent range.  However, a managed short fund (HDGE) is not confirming the move lower in SH.  As we’ve stated before, this condition warns of a larger and more sustained correction than many traders currently expect.

Now we’re seeing volatility diverging from SH as well. In the bottom panel of the chart below we show mid-term volatility (VXZ) as an example.  Since we’re intermediate term investors we prefer to watch mid-term volatility rather than daily volatility (VIX).  VIX moves around too rapidly for us to get much good information about future market potential.  By looking at volatility further out on the term structure we get a better feel for a longer term trend. What we look for is a spike in VXZ after the market has traded sideways.  We haven’t got that condition yet, but the stage is being set for just that type of a move.

HDGE vs. SH vs. VXZ

SPX is just a few percent above the mid point of its recent range and needs some follow through to make us more comfortable with this market.  We suspect that the bulls will try a push into the 1550 to 1575 range in SPX over the next few days.  The bears will start showing up in force the closer we get to 1575 (all time highs).  This battle will give us a lot of information about the intermediate term trend.  The way HDGE and VXZ react is one of the things we’ll be watching for a direction. Until we get more information we’re comfortably positioned in our portfolios where we’ve started to protect profits, but will participate a little if the market continues to push higher.

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