Volatility

Volatility is one of the more important indicators for a serious investor to follow . Volatility is a measure of risk .... the Higher the Volatility -- the Higher the risk .... the Lower the Volatility -- the Lower the risk . Volatility is also a key factor in determining valuations in options and derivatives ( see Black-Scholes modeling ) .

Why is this significant ? As a determinant of sentiment , "fear" and "greed" are very important to the underlying psychology of a particular stock or index . Knowing how the " crowds " think and act can help an investor act appropriately ( usually contrarian ) rather than follow the lemmings off the cliff.

Two of the more popular Volatility indices in the Equity markets are the VIX -- which measures Volatility in the S&P 500 , and the VXN -- which measures Volatility in the NASDAQ 100 . These indices are thought of as "reverse " indicators . They usually move in the opposite direction of their underlying index . When fear abounds , the indexes will fall and the Volatility indexes will rise . When fear subsides , indexes will rise and Volatility falls.

When Volatility rises to extremes , it usually signifies a panic selling mode , and signals a " Buying " opportunity . When Volatility falls it usually signals a "complacency " and a rising market , and can be used a " Selling " opportunity .

What are the Volatility indices implying now ? A possible topping out of the market -- it may be time to be cautious and defensive in investing , and even selling some overextended positions .

The Fed

Today the Fed published the minutes of the August 8 meeting of the FOMC .
The takeaways are as follows :

" The growth of consumer spending slowed considerably in the second quarter after the surge in purchases around the turn of the year "

" Nonfarm payrolls increased in June and July, but more slowly than in the first quarter "

" Residential construction activity contracted in the second quarter. Single-family starts declined in June to a level well below the average of the previous twelve months "

" In view of the elevated readings on costs and prices, many members thought that the decision to keep policy unchanged at this meeting was a close call,” .........“ But with economic growth having moderated some, most members anticipated that inflation pressures quite possibly would ease gradually "

``The full effect of previous increases in interest rates on activity and prices probably had not yet been felt, and a pause was viewed as appropriate to limit the risks of tightening too much,''

In other words , the Fed sees enough slowing in the economy that it can wait and see before it decides to make any more rate increases --- IF any .... the market can relax as long as inflation #'s don't creep up any more ...... the downward pressure in Oil , Natural Gas and Copper the last few weeks can assuage investors for the time being

Playing Defense

AS the economy decelerates , investors need to focus on how their portfolios are balanced . Presently , with slowing growth in the future ( UBS cut its 2H 2006 GDP estimate to 2% from 2.5% , and 2007 GDP to 2.2% from 2.5% ) we need to find the stocks and indices that will perform well as earnings begin to slow .
In such an environment , stocks with little or no correlation to the economy deserve to be over-weighted in a portfolio . These stocks are the Consumer Non-Durables ( XLP ) , the foods , toothpaste , tobacco , beverages , etc. , that people buy no matter what the economy does . Conversely , Consumer Cyclicals (XLY) , the autos , papers , hotels, manufacturers are the stocks that do less well in a slowing economy . Thus , we should overweight XLP and underweight XLY

Time to short commodities ???

The end of the Fed's rate hike escapade has brought about serious debate as to whether they've truly paused , or if they may raise at some later date.
With the Fed Funds futures contracts for September and October showing less than a 10% chance of further rate increases , the Treasury market has voted with their $$$ . With yields below 5% for the whole curve , they seem to feel comfortable with curve inversion.
Intermarket relationships show interesting action in the commodities markets as well . One of the Fed's unstated goals is to keep commodities in check , with some Fed watchers calling for Gold prices to be $450/oz. as equilibrium ( quite a bit away from where we are now ) . Recent selloffs in key commodities indicate that the Fed has accomplished some of its ambitions . Gold has fallen 14% from its $732/oz. high , the CRB index has fallen 8% from its highs , Silver is 18% off its highs , Copper is 17% off its highs , and Crude is 8% off its highs . The question now is , how much further can these commodities fall .....

Taking short positions in any market is always tricky , especially in markets as Hot as commodities have been the past three years . The key to being short the commodity groups is knowing 1) inflationary expectations 2) demand/supply 3) commodity trader activity .
If we judge correctly that the Fed is done raising rates , and weakening global demand coupled with increasing supplies , are in the future , then we should look at shorting commodity indices ( DBC , USO , SLV in the ETF world ) or outright commodity contracts .

Recession on the horizon ???

In the last 60 years , the U.S. economy has slid into recession each time that we've had an inverted yield curve --- defined as 2- yr. Treasuries yielding more than 10-yr. treasuries . This phenomenon has been prevalent with the curve inversion ranging between -1 to -8 bps since June . At present we also have FedFunds (5.25%) higher than the whole curve : 2-yr. 4.86% , 5-yr. 4.74% , 10-yr. 4.80% , 30-yr. 4.92% .
The Fed and the White House don't want to scare the consumer with this type of news , but as the 3Q ends and the Elections pass , economic #'s should continue their downward path...... Harvard Professor Martin Feldstein, who chairs the National Bureau of Economic Research, said a recession could occur if households made a "decision to start saving again" rather than keep spending as the housing market fades ........ and , as economist Gary Shilling says , "The Federal Reserve almost always overshoots. Since 1954, the Fed has undertaken 11 credit-tightening campaigns, and in only one of those -in the mid-1990s - did they succeed in effecting a "soft landing" for the economy. So the odds are that they will keep going until something happens, and that something is almost always a recession. "

10-Year Treasurys

So , where does the 10-year Treasury find resistance ? The next key level is the 200-day m.a. found @ 47.95 .... where did we close today ?? 47.91 .... this may be a key resistance point before we make any more highs in price / lows in yield ... next week's economic #'s are chock full of enough ammo to delay or confirm any moves : 2Q Unemployment , ISM Index , U. Mich sentiment , Chicago PMI and the Fed's FOMC minutes

Bullish on Bonds

When do we see bullish action in the T-bond pits ?
The bullish Treasury action has been occuring for 2 months and will continue as Retail Sales and Housing #'s continue to soften . The consumer is choking on debt and is spent , and as the consumer goes so does the economy ( 70% of GDP is consumption- source BEA ) . A slowing consumer will lead to slower GDP which will lead to lessened inflationary expectations . The yield on the 10-year hovers near 4.80% , and the TIPS has a "real" inflation risk of 2.55% , barely higher than December 2005's final tally of 2.33% .
--Check the futures activity of " smart money " , which gets posted on the commodities exchanges data library .... they are now showing that "large noncommercial " traders ( speculators/hedgies ) added 63,000 contracts to their existing long position, bringing their collective net long to 261,215 contracts, the second-highest tally ever. The high water mark of 263,723 was set March 21
-- Or check the commodity floors ... today a Very bullish trader sold 20k December 105 Treasury puts
-- Housing is finished , it was too much $ chasing bubble dreams and it has popped ......... speculation + too much money = bubble prices ........
New Homes Sales ---- DOWN
Housing Starts ---- DOWN
the Mortgage Bankers Association's purchase application index has DROPPED to 385.9 from 425...........
so how do you play this as an investor ???? ..... stay long the 10- and 30-year , stay short the Homebuilders and start shorting the big S&L's