Complacency and the VIX: Hedge funds in a tough position

By Danny Riley

The Asian markets closed higher and Europe is down across the board. Today’s economic calendar starts out with four economic releases and some Fed speak. If you think yesterday was a long day, just wait for today …

Moody’s
I cannot speak for everyone, but I keep looking for some light at the end of the tunnel. After a ferocious credit crisis (still going), I find it very hard to believe that ourelected officials have not negotiated a deal to reopen the government. Why is it that we have to do a countdown to a default? And what does that mean for us individually? Because we can’t seem to get anything concrete out of the politicians, who can we get it from? Who can we trust? Well, for my money, I am going with Moody’s CEO Raymond McDaniel, who told CNBC that “It is unlikely that we go past October 17 and fail to raise the debt ceiling, but even if that does happen, then we think that the U.S. Treasury is still going to pay on those Treasury securities.” Does that cure all my anxieties? Not really, because it always seems like it’s on to the next problem.

Complacency
Yesterday the Dow closed on a new one-month low and the VIX spiked another 13% as it nears 19. I have been talking about complacency for the last two weeks. Yesterday the Chicago Board of Options (CBOE) volatility index traded as high as 18.93. The “fear gauge” spiked to the highest level since June, when the talk of a possible Fed taper was at its high. While there is a lack of turbulence on the surface, that tends to be the deceptive part of complacency. Many of the big investment firms and hedge funds have cut way back and are trying to hold on to gains. After hedging so many times and then having to lift the hedge when the markets start going back up, many firms have decided against throwing hedges on every time the S&P sells off. If that’s the case and the S&P starts going down hard, the hedge funds will be forced into selling.

Our view: The overall price action of the ESZ got really weak late in the day. I know certain people question the MiM, but there have been too many instances of late where the MiM showed big to sell and the ESZ sold off, or like yesterday when the MiM started out on the buy side and gradually turned to the sell side with the S&P trading in lockstep during the late-day 7-8 handle selloff. As far as today goes, we think we initially could see lower prices and them some type of bounce. When the markets go quiet like they were yesterday and all the downward thrust is used up on the open, the S&P just starts drifting higher. There was no new buying during yesterday’s rally, it was all short covering. Our view is to buy the early weakness and sell the rally. As we said yesterday, at some point there is value in fear.