Why the Stock Market is Set for a Dramatic Swing8 min read


It’s been geopolitical information overload of late… from Trump’s drama to tensions with North Korea, Russia and China, combined with ‘successful’ elections in France, investors are in a fog of blissful ignorance. Growth in the West is anemic. The US put up a pathetic 0.7% GDP increase in Q1, and no one cares – the market has trended higher.

Dogmatic faith from investors has led the markets into record territory. Global central banks have provided an apparent never-ending hedge that has market participants fully vested, confident the rebound that began in March of 2009 will continue. At least that is what the VIX (CBOE Volatility Index), also known as the ‘fear gauge’ of the market, is telling us.

VIX Chart
chart source: Market Watch

 

The CBOE VIX Index was down 2.21% Wednesday afternoon to 9.74 after hitting a more than 23-year low of 9.62 earlier in the session. The index touched the nine handle in intraday trading the previous week, rebounded strongly, but has collapsed in the days following centrist and pro-EU candidate Emmanuel Macron’s victory in France.

Special note regarding Macron’s win and gold:
Gold moved slightly higher following his win. Long-term, it’s easy to understand why Macron is VERY bullish for gold. We wrote about this well before his victory in an article titled, Macron Victory is Bullish for Gold.

Take a look at France’s soaring debt over the past ten years. Over the last decade, two mainstream parties – a conservative and socialist – ruled France. Macron, who has been a member of the main socialist party in France and was appointed deputy secretary-general under François Hollande’s socialist government in 2012, is an establishment candidate. The idea that he will lead France down a new path of higher growth and lower debt has no basis. He will continue the policies of his predecessor and move the country closer to its next financial crisis. We are not insinuating Marine Le Pen would have been able to fix any debt problems; her policies were socialistic too. This is France after all.

France Rising Debt
source: Trading Economics

 

Back to the VIX…

 

There are only three historical periods dating back to 1990 when the VIX went sub-10: December 1993, January 1994, and Dec 2006/Jan 2007.

VIX trades to 23 Year Low
source: Zero Hedge

 

Exuberant buying of US real estate and the North American stock markets between late 2006 and early 2007 was preceded by a sub-10 VIX rating. We all know what followed…

Today, we are focused on what can happen to the VIX, and, more importantly, the markets after a prolonged period of little to no perceived risk.

Market participants are pricing in the lowest volatility in 23 years! Should we believe it? Of course not.

If the aftermath following the previous three times the VIX was this low is any indication of what’s coming next, buckle up. An extreme move for the markets is likely coming before year-end.

First, let’s look at the initial two periods the VIX dropped below 10, which occurred in late 1993 and early 1994. At the time, the world was less than twelve months away from the Mexican Peso crisis. The ‘Peso Crisis,’ as it was dubbed by economists, was one of the first international financial crises that began with a capital flight transcending borders.

A white paper written by Maarten van der Molen, The Tequila crisis in 1994, documented how quickly a financial crisis can emerge:

 

“December 1st, 1994

The new Mexican government, headed by President Zedillo, takes office.

December 15th, 1994

The Wall Street Journal publishes an interview with the new Finance Minister Jaime Serra Puche, in which he denies that Mexico will devaluate the peso. The next day, USD 855 m leaves Mexico.

December 20th, 1994

The new cabinet concludes that the situation is unsustainable. Therefore, the Central Bank of Mexico announces a lift of the upper band of the exchange rate by 15%, an effective devaluation of the peso.

December 20-21th, 1994

In the two days after the announcement, USD 4.6 bn leaves the country, half of the foreign exchange reserves.

December 22th, 1994

The intervention on the foreign exchange market is lifted, and the peso is allowed to float freely. The total devaluation of the peso amounts to 35% by the end of December.

Peso Crisis

January 26th, 1995

The IMF announces a rescue package of USD 7.8 bn.”

 

 

While there have been many currency crises across the world, the Peso Crisis is a reminder of how quickly they can emerge less than a year from the VIX at historic lows. When markets are blind-sided during a period of complacency, panic takes over (to the upside or down). In fact, in all three instances when the VIX dropped to such low levels, within a year the volatility index exploded and financial crises, resulting in significant bailouts, ensued.

We believe the VIX may have already found its bottom at 9.62. While it may not skyrocket initially (it closed Friday at 10.40), it is historically known to make huge moves after dipping below 10…

In a Zero Hedge article titled A VIX Below 10 Means This… the performances of the market following historic volatility lows are documented:

“In each case, US equities were modestly lower (down 2 to 6%) one year later and in 2 of the 3 instances they were down 2-6% in three months’ time.  More importantly, the following years (1995 and 2008) show a remarkable dichotomy of returns (up or down 37%).”

The article confirms that,

“The takeaway from these examples is clear: in the unusual instances (just 0.13% of the days since 1990) when the VIX closes below 10, one year forward returns have all been negative. In one case (2007 into 2008) the following year was terrible.  In the other case (1994 into 1995) it was great – up 37.2%.”

 

VIX Volatility | The Set Up

 

Portfolio manager Jacob Weinig of Malachite Capital, a smaller firm with $282 million under management, was on CNBC last week to talk about the falling VIX. He stated,

“I’ve heard a lot of people saying recently that the VIX is dead, that the VIX doesn’t matter anymore … the VIX, in fact, is doing exactly what it’s meant to be doing. It’s reflective of the actual market volatility that we see.”

And that,

“We have a historically low level of realized volatility in the markets. In fact, Q1 was the lowest realized volatility on record since 1965.”

 

Investopedia reported:

 

“On March 21, the S&P 500 fell 1.48 percent, ending a 109-day streak without falling by more than 1 percent on a closing basis. The longest such streak since September 1993, and the seventh longest of all-time.”

 

What isn’t certain is if the next move will be an inflationary fueled rise or a contraction caused by a currency collapse (the end of the EU or contagion via a credit collapse? Also, in Canada, think Home Capital Group and a possible spillover scenario).

Home Capital Group could collapse
On Friday, the Financial Post reported, “Home Capital Group Inc. said it’s seeking new sources of funding to counter a run on deposits and warned that the failure of the Canadian lender would have significant “knock-on effects” in the broader mortgage market.”

 

Our belief is that the downside market risk is stronger, given weak growth and high debt levels. That doesn’t mean the central banks can’t step in with yet another round of stimulus following a broad market sell-off, of course.

Best-selling author and financial commentator Jim Rickards believes it is only a matter of time before confidence in the US dollar evaporates – at least temporarily. Perhaps it will happen towards the end of summer when the US Government is expected to run out of funds and face another potential shut down. (This could also be a catalyst for the VIX to explode.) President Trump himself tweeted to this point on Tuesday:

Trump threatens government shut down

Trump threatens government shut down

 

A few days later, on May 9th, Jim Rickards tweeted:

Trump to enlarge the problem of government debt

 

If the American Government shuts down in August, will it not shake confidence in the U.S. dollar? Think back to August 2011 for your answer – just weeks prior to gold hitting its all-time high.

 

The Last Saviour

 

As debt continues to pile up in the West, eventually someone is going to have to pay for it, or we’ll see a national default.

Jim Rickards has predicted it will be the IMF (International Monetary Fund), which currently possesses the only clean balance sheet, who will bail out the world’s central banks in the next financial calamity.

The IMF will be using its SDR currency, known as a ‘special drawing right,’ to bail nation(s) out. Read our in-depth report here for all you need to know on this subject.

 

How is the SDR Valued?

 

According to the IMF, “The value of the SDR was initially defined as equivalent to 0.888671 grams of fine gold-which, at the time, was also equivalent to one US dollar. After the collapse of the Bretton Woods system in 1973, the SDR was redefined as a basket of currencies. Effective October 1, 2016 the SDR basket consists of the US dollar, euro, the Chinese renminbi, Japanese yen, and British pound sterling.

The value of the SDR in terms of the US dollar is determined daily and posted on the IMF’s website.”

 

With China now firmly inserted into the IMF ‘club,’ a bailout from this institution will be accepted globally.

History has proven that when the VIX falls below 10, we are nearing a precipice; and the market is preparing for a huge move in either direction. The lack of volatility and malaise which has washed over western stock markets cannot last. Stay vigilant and informed as cracks in our debt-laden armour widen.

All the best with your investments,

 

PINNACLEDIGEST.COM

 

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