Volatility Outlook for June 2015: Back on top in June

That’s life, that’s what people say

You are riding high in April

Shot down in May

But I know I’m gonna change that tune,

When I’m back on top, back on top in June

Frank Sinatra

May Recap

May ran pretty much according to seasonal trends over the past 10 years. After a dip in the early part of the month, it recovered in the middle part of the month and then ended with a whimper. The middle of the month featured a surprise mini rally over a couple of days that exacerbated the Contango around the VIX Futures expiration date and led to a very nice month for the XIV. XIV ran up to 15% through the middle of the month with a strong 10% rally in the option expiration week before finally cooling off near the end.

VCO stayed in the upper band of the historical averages and started cooling off near the end of the month. But despite it all, it was always above the historical average in a blue line below.

June Outlook

June has a different profile than May. June always starts weak, but a rally takes shape as the month progresses and after option expiration, the index just takes off and closes off strong.

June is also historically a very strong month for the XIV. On average the XIV makes 13% in the month, but you will have to wait the whole month to get that.

Contango Roll starts off below the magic 10% line for the middle part of the month and then closes off strong, which is rather unusual. But apparently, investors are worried in the first part of the month expecting an additional drop to come after the May weakness and when it doesn’t come, they pile on the bus as we enter into July and the 4th of July holiday. Always remember that pre-holiday weeks are great for the market, the market exhibits little volatility and trends up. During this bull market, pre-holiday weeks have lead to large percentage gains which were later consolidated (you saw a replay of this with the Memorial Day holiday)

Rally Update

We’re in the middle of one of the longest and weakest rallies of this bull market. This rally is now 57 days strong, but has only returned 4.44% since the last valley.

Given the extended valuations of the market, that is completely understandable. The market is now trading north of 21 P/E and the higher the valuations, the harder it will be to make percentage gains. It now takes 20 points to print 1% in the SPX, where that used to be just 13-14 just a couple of years ago. Investors need to understand that it is harder to print percentage gains going forward.

However, calls for an imminent market collapse are premature. Unless we have some kind of uncontrolled event coming on, there is a lot of cash sloshing around ready to prop up the market and buy every dip, regardless of weakening corporate earnings and extended valuations. The big unannounced event this year is the weak performance of US treasury bonds.

Long term bonds (TLT) are now negative on the year and is one of the bottom 5 major asset class performers on the year. Let’s not forget that TLT is the biggest market in terms of volume, so if that market is experiencing a drawdown (which seems to be gathering strength – the 50-day slope is -12% at this point), there is money flowing out and seeking a home. The US dollar (UUP) and China (FXI) will take some of that as evidenced by the UUP stellar 6% year to date and China’s 17% return, but some of it will find its way to the US stock market in search of safe dividends and that will keep the stock market in check.

While “buy the dip” hasn’t been as lucrative as before, “short the rip” is not a profitable strategy yet. We need the market to first register a drawdown (2% drop over 3+days) which hasn’t happened yet. Then we need a substantial 7-10% drop, followed by a rally to a lower high for investors to even consider jumping on the short side of the market. So for now your best opportunity is to trade the XIV and take advantage of the Contango expansion happening in mid month prior to the future expiration week as VIX1 comes down to meet spot VIX while VIX2 stays at a higher premium.

The XIV has been a very strong performer this year especially over the past 4 months registering 80% return over that span. For the year, it is the best asset class to date with a 45% year-to-date return. Look for that outperformance to continue into June.

Historically SPX rallies end higher than the 0.5% over the prior top we have registered so far. We can expect the market to reach 2140 at least in the month of June barring an all out war in the Ukraine and a Greek default.

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