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Waiting to Exhale


My expectation is for volatility to return this month and I continue to watch our commodity proxy (the CRB) as a clue to that fuse.

The waiting is the hardest part
Every day you see one more card
You take it on faith, you take it to the heart
The waiting is the hardest part

(Tom Petty)

With the blink of an eye, the summer of '06 is a distant memory as players settle into their ol' familiar digs. The slow summer slither was kind to the bulls and the ursine learned anew that they should never short a dull tape. With the change of seasons comes a change of pace, however, and investors should brace for a new market persona to emerge.

The story of compression is a familiar one. As the rising tide of liquidity raised all asset class boats on the back of the bubble (at the expense of the U.S dollar, which lost almost a third of its value), equity volatility abated in kind. It makes sense, if you take a step back and examine the dynamic. A lack of liquidity increases movement--anyone who's tried to accumulate a thin stock can attest to that--and, ergo, a flush of liquidity will have the exact opposite effect.

We've spoken at length about the current inflection point in commodities and the inherent ramifications for U.S equities. With the five year trendline in the CRB now resting overhead, the question we must ponder is whether we're witnessing a sea change in risk appetites. It's a grand observation and one that continues to unfold before our eyes each day. And as we enter a new month and begin to cast an eye towards year-end, it's a potential outcome that warrants consideration.

Trading, in its most basic form, is an attempt to capture the disconnect between perception and reality. Only time will tell if volatility levels, as an inverse function of liquidity, will begin to squeeze higher and unwind this artificial compression. Regardless of the timing, however, one thing remains certain. In an attempt to capture the ever-smaller movements of underlying financial instruments, hedge funds, which are paid to play, have increased the size of their bets to maximize gains. We've seen it through the proliferation of "income funds," which sell cheap upside calls to capture crumbs of return, and we've seen it across the Street as players make bigger bets, many times with leverage, to extract maximum exposure on their bets.

My expectation is for volatility to return this month and I continue to watch our commodity proxy (the CRB) as a clue to that fuse. While we may witness a drive to the upside at the expense of the US dollar--please keep an eye on metal equities as they attempt to break out above XAU 150--my inclination is that the benefit of the doubt rests with the bears. My mainstay stochastic measures are extended and toppy, September is historically the worst performing month of the year; volatility levels (VXO) generally move in opposite direction of the price action and we've got this ominous looking script, which tracks the NAHB Housing Index vs. The S&P 500 with a 12-month lag.

There are no guarantees, of course, and if the market has proven anything over time, it's that she's a lot smarter than we are. I opined last week that if the bulls are to wrestle back control, three conditional elements would likely need to materialize. First and foremost, the CRB needs to regain the trendline and call a collective "offsides" on those pressing their downside bet. Market breadth, which measures the winners vs. sinners each session, would need to step up and stand out. And finally, the homebuilders, which have suffered organic two for one stock splits in the past year, would need to absorb the bevy of bad news and lead us higher. In that vain, and given yesterday's 3% slippage in the HGX, Beazer Homes and KB Homes, two homies with overnight negative news, become important market vanes for investor sentiment today.

Most market moves are characterized by three phases--denial, migration and panic--and my sense is that, for the broader tape, we remain in the early stages of that cycle. That doesn't mean that we should run for the hills, naturally, but it would behoove investors to appreciate the distinction between what was (a long stretch of low volatility) and what will be (sharper moves and the potential for increased risk aversion). In short, I can't tell you whether September will be a Debbie Downer as a multitude of dynamics will ultimately shape our course. But I will offer, with a semblance of confidence, that the risk to the tape is higher than most folks think.

Good luck today.

Position in metals

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at

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