In today’s issue, we delve into a first look at trading in 2022 – complete with an on-depth look at market volatility and more!
Market Breadth Worries?
A couple weeks ago, we discussed about how a lack of market breadth – that is, the absence of gains across a number of stocks in various sectors – was a warning sign of market weakness.
Breadth is a measure of stock market health, so a narrow focus on a small number of stocks, and a concentration of gains in those few issues, Can be a real red flag.
Gary Schilling recently explained:
The 10 largest stocks by market capitalization account for 30% of the S&P 500 Index’s total value, and five — Apple Inc., Microsoft Corp., Nvidia Corp., Alphabet Inc. and Tesla Inc. — accounted for about a third of the index’s 27% gain in 2021. In short, if anything goes wrong with that handful of equities, as well as mutual and exchange-traded funds based on the broad market, everyone might be in trouble.
Considering that this kind of narrowing of market breadth is usually followed by below-average returns in the S&P 500, the possibility of a selloff in these growth stocks could be in the cards for 2022.
The prospect of rising interest rates in the year ahead points in the same direction. These companies tend to be sensitive to rate hikes, and — with valuations far beyond historic norms — the likelihood of investors reassessing the value of those future profits could mean a drastic drop in stock prices, which would almost certainly sink the entire market.
While this is one potentially bearish factor, and traders are advised to carefully watch the performance of the top-heavy benchmark indexes, it is not a sufficient reason to assume that short positions are now in order. As always, you need to research companies and make decisions on individual stocks accordingly.
At the same time, index traders are advised to keep in mind that we are still in a bull market!
With a new year under way, now is a good time to reset your portfolio strategy. Call FFR Trading at (800) 883-0524 today, or click the link below, to schedule your free strategy call.
Liquidity is King
The biggest counterweight to any bearish argument is the overwhelming amount of liquidity in the financial markets.
As Fed stimulus continues (even moderate tapering has not yet begun… the ‘new money’ spigots remain wide open), new inflows continue to power the bull market’s never-ending story.
This trend is reinforced by the historical prevalence of January inflows, as shown on the chart below. As this chart from Market Ear shows, there are more mutual fund inflows (that is, cash added to investment accounts) in January than in the other 11 months of the year combined.
Fed monetary stimulus and government COVID relief payments, including those to parents of younger children that continued through 2021, have created massive “cash on the sidelines.”
Additionally, the paper gains achieved by millions of retail investors are, in many cases, being moved from the highly speculative meme stocks and crypto currencies into more conservative, longer-term vehicles. All of this is fueling fund inflows.
January of 2022 could see even more fund inflows than the average.
Chart courtesy of themarketear.com
These mutual funds will continue to buy shares, with a likely emphasis on the same leading growth stocks mentioned above. This self-perpetuating cycle underpins a probable continued upward run in the markets.
As we’ve been pointing out for months, all that money has to go somewhere. With real interest rates less than zero, bonds are not an appealing target (to say nothing of cash instruments like CDs and savings accounts!)
What this means for traders is that we must balance our skepticism regarding the health of the economy and the market with an understanding that liquidity is still king, and unless (until) a sudden disruptive event occurs, the possibility of a bear market turn remains low.
A Good Volatility Play?
Over the past 6 months, the CBOE Volatility Index (VIX) has spiked 5 times, as unexpected sudden developments shook the market. Each of these spikes was preceded by a dip below 16.
Large account traders use VIX to hedge their risk, so most upward movements are generated by a sudden realization that “protection” is needed. Traders who already hold long positions in the VIX can profit nicely when the “big boys” decide they need the coverage.
Consider this analysis – which accompanied the chart below – from Market Ear:
VIX has crashed since the early December panic. VIX is approaching the “new” natural floor level at these levels. Expecting much lower VIX from here is probably a very late trade. Ask yourself: how much downside vs upside is there in VIX from here and then assign some probabilities. Regular readers of TME are familiar with our overall view on volatility and protection: “buy it when you can, not when you must.”
As the index heads back down toward recent lows, it might be worth researching the possibilities for VIX call options, or taking a position in a long VIX ETF.
With premiums on Jan. ’22 $20 VIX call options under $2.00, the possibility of a profitable move (above $22) depends on some kind of market shock occurring in the relatively short time to expiration. Longer-dated expirations cost more, but give you more time for events to unfold. This is always the issue with options… how much time can you buy at what price. However, the premium on VIX call options might be considered “affordable,” if you think a major spike is at hand.
While this may seem unlikely, the potential gain if we do see a spike similar to what happened in late November, or even mid-September, would be substantial.
For those with a lower risk tolerance, the ETF strategy provides more time flexibility, and is a less-risky way to play this idea.
The VIX has only spent five weeks below 16 in the past year, so the downside seems to be limited. Traders who expect continued stability in the markets would not want to consider this strategy. But for risk-tolerant traders who think the S&P is likely to experience more jolts like the ones we saw in 2021, this could be a strong idea to consider.
This is a speculative idea and should be researched in more detail before trading. Only trade with funds you can afford to lose. Call FFR Trading at (800) 883-0524 or contact us here to discuss whether this strategy makes sense for your trading goals.
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