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Todd Harrison: The Federal Reserve Warns of Compression


The tape is coiling under the seemingly calm financial surface.

Editor's Note: Todd posts his vibes in real time each day on our Buzz & Banter where subscribers can follow over 30 professional traders as they share their ideas in real time. Want access to the Buzz plus unlimited market commentary? Click here to learn more about MVPRO.

Step on a steam train; step out of the driving rain, maybe.
The Dow Jones Industrial Average (INDEXDJX:.DJI) enjoyed its best day in a month yesterday as investors exhaled following the FOMC meeting.
While the language was largely consistent with expectations -- we've come to expect wavering and other "data-dependent" vernacular -- it wasn't enough to upset the apple cart as investors ready for the long holiday weekend.

One interesting tidbit did emerge from the Federal Reserve meeting: Committee members noted that the low system volatility represented increased investor risk appetite.  This is a theme we've discussed on Minyanville for some time, and it makes intuitive sense. 

In periods of low volatility, investors ratchet up leverage in order to magnify paltry returns; this creates "compression" that builds under the seemingly calm financial surface.  John Succo addressed this dynamic 10 years ago, and the structural implications remain the same.
On May 5, when we warned of an approaching "volatility storm," we noted that this isn't a timing mechanism but rather a contextual red flag. Per the chart below, currency volatility, interest rate volatility, and S&P 500 (INDEXSP:.INX) volatility are compressed across the board.

That makes sense in a world where liquidity is artificially infused into the financial fabric -- volatility is the opposite of liquidity -- but not so much as the punch bowl is being taken away. 
And it is clearly something that is on the radar of Federal Reserve officials given the interconnectedness of the global financial machination.
Random Thoughts:

  • Ironically, this column -- Why I'm Exiting the Digital Media Business -- continues to garner "clicks."
  • Yesterday, we touched on how this new process impacts -- or doesn't impact -- our community.  If you missed that, you can read it here.
  • Yes, volatility levels can remain compressed for years at a time; note the periods between 1992-1996 and 2004-2006 in the chart below.  I remember them well; it was death by 1,000 paper cuts for anyone who overtraded.
  • The Bloomberg Smart Money Flow Index -- described here -- is another contextual red flag. Nothing is omniscient given the multi-linear dynamic of the markets, but some clues are worth watching; this is one of them.
  • Apple (NASDAQ:AAPL) continues to flirt with a technical breakout above $605. Should the bulls hold that level, it will provide nice and tight risk definition for those looking to play the upside.
  • The small caps, as measured by the Russell 2000 (INDEXRUSSELL:RUT), continue to struggle, both on an absolute and relative basis. The chart below suggests that the S&P and Russell will adjust to this disparity on a forward basis.
  • Remember, the market will take the time premium (theta) of options before the three-day weekend.
  • It remains to be seen if "sell in May and go away" plays through this year.  Per the chart below, that strategy allowed for a lower purchase (cover) in four of the last five years despite the parabolic frolic, but if you stayed away, you were left behind.  Of course, we're talking about one of the most powerful stretches in the history of financial markets, and past performance is no guarantee of future results.
  • I said this yesterday but it bears repeating: Family and health; health and family.  Everything else will fall into place.

Twitter: @todd_harrison

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