Momentum can be played on both sides of the market. When money is flowing and running hot the upside gains are delicious, but when money is flowing out then the rewards for playing downside can be just as tasty. We play in a market ruled by liquidity and given the trillions of capital thrown at it each day it’s no wonder we look at momentum as the key driver. Play the downside – profits are fast! Play the upside, a bit slower but more long-lasting. To be certain markets historically trend upward, but we cannot always make our ‘nut’ by being bullish all the time. The indices are heading for trouble (if they aren’t already), and we have to be nimble to play both sides aggressively (see chart below).
What’s Happening with Volatility
When we see volatility rising in markets we know it means one thing – fear is coming in. We are constantly moving along the spectrum of fear and greed, putting our dollars at work based on sentiment. We can capture that sentiment quantitatively by looking at the volatility index or VIX. This fear gauge shows at certain points where the emotions lie. As contrarians we try to exploit these extreme levels of complacency (too bullish) and fear (too bearish), looking for capitulation or excess greed. The public is usually wrong at these turns, hence we find mean reversion. Currently the trend in volatility is up due to the recent uncertainty – economy, jobs, debt ceiling, inflation, downgrades, and Europe. Perhaps the economy is slowing down and the market is predicting it. Remember, the market is a discounting mechanism and may be telling us what the economy will be like in early 2012. In recent times the rise in volatility has been sold – spike peaks – but this time that trend may be stronger than anyone thinks (see chart).