Two ways to look at this. The biggest rallies in market history take place when volatility is this high … So do the biggest plunges. This is basically a summary of a discussion I had with employees this morning. Not much has changed in the past few hours.
As far as what to expect tomorrow and next week, well, first I have to admit that there is one thing that has me really nervous, and that is the current situation has an eery similarity to October 1987. The market is coming off a serious peak from a few weeks ago. The Dow and the S&P 500 are now below their 200-day and, more importantly, their 39-week moving average. Closing below the 39-week moving average was a VERY BIG DEAL back in 1987.
It’s also options expiration week. The Friday before Black Monday in October 1987 was options expiration. Importantly, the May S&P 500 puts all expire tomorrow morning. They don’t carry on through the day. Now most people who trade these options know this, I think. But one thing that happened in 1987 is that a lot of put protection expired over the weekend.
Advisors are still surprisingly complacent. Back then, the level of bullishness among advisors and individuals was surprisingly optimistic, even though the Dow had already fallen more than 10%. In 2010, the stock market has fallen almost as far. Advisor sentiment is still relatively optimistic, considering the damage done to the market.
Congress is also having an influence. Back then, after Ivan Boesky and Michael Milken saw their empires crumble in 1986, Dan Rostenkowski and the House Ways and Means Connittee voted on October 15, 1987 to implement a tax on takeovers. Today … TODAY the Senate voted to end debate on financial reform legislation (not siding with any particular political philosophy, just pointing out the coincident timing).
You also had a currency crisis caused by burgeoning sovereign debts, only it was the U.S. back then. The deficit was so bad that Treasury Secretary James Baker suggested that the U.S. may actually force the dollar lower to correct imbalances. A few days later, in the Sunday October 18, 1987 New York Times, Baker hinted that the U.S. might not intervene to stop any dollar decline. Today, it’s the Euro that is crumbling. What’s interesting about today’s action is that the Euro and the U.S. stock market, which had been joined at the hip, lost their connectedness. The Euro skyrocketed (how ’bout that reverse head and shoulders!), while the U.S. stock market tumbled.
Meanwhile, a key economic indicator we follow is the difference between yields on Aaa-rated and Baa-rated bonds. That spread has been widening for a while. It’s a sure sign of stress in the credit markets. Also, Eurodollars are rising, although not as fast as the TED spread indicates. That spread is widening fast, but mostly because of the decline in T-bill rates.
The ONLY sentiment indicators showing any signs of panic are the two options indicators: the VIX and the put/call ratios. You might be able to make a case that nibbling at a bullish debit spread might be in order. This is the same bullish signal that we got at the close on May 7. That one worked like a charm.
One other thing to keep an eye on tomorrow is, as Todd Harrison notes, central banks across the world have a history of taking action on options expiration. The way option gamma works, it’s a real magnifier. And it could wreak havoc on the open due to the expiring S&P 500 options.
If you’re a subscriber to one of our services, you know that we are VERY LIGHT on positions.  For instance, our only put sale we have is on MCO; MCO is only down a few pennies this week. The reason we don’t have more on is because we never could find the volatility necessary to get the right trades.
With that in mind, I have to admit that I am liking this volatility. Because it never lasts forever. And once volatility peaks, it creates opportunities that last months, even years.
– Don
