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The Fed — Not Omicron — Is Driving Volatility. Don’t Buy This Dip Yet

by | Dec 14, 2021 | Stocks

If there’s one question finance professionals get asked the most, it’s what makes markets go up or down?

If you happened to ask the “finance professionals” at CNBC on Tuesday, they’d have said something like “ZOMG DEFINITELY OMICRON.”

Source: CNBC

News flash: It’s not.

In reality, however, the day-to-day answer is usually… nothing.

There are exceptions, of course. Earnings, mergers and acquisitions, scandal, crowding — any topic that hits the airwaves will exacerbate the noise in the Brownian motion of market pricing.

But when government policy changes significantly, you can bet the pros are going to make significant adjustments. And so will we when it comes to our Fortune Research weekly watchlist…

When the Federal Reserve meets Wednesday, there’s a slight chance it will increase interest rates by 25 basis points, from near 0 to 0.25%.

In and of itself, that won’t be a big deal… The interest rate on the two-year Treasury is sitting at 0.65%, having already priced in close to three rate hikes over the next year.

Source: Bloomberg

Moreover, the Fed has already telegraphed to the market that it plans on tapering asset purchases, and is looking to raise rates twice next year.

But if the Fed ditches its playbook and calls an audible where “next year” becomes “this year” — due to the sudden realization that inflation is not “transitory” — then those finance professionals will adjust their books accordingly… all at once.

And we’ll have to update our Fortune Research weekly watchlist again.

Just a couple of weeks ago, I mused, “When are these guys (hedge funds) going to lock in their epic year bonuses and take the month off? After all, that’s exactly what they did back in 2018.”

Source: Bloomberg

I followed that up by saying, “Frankly, I think the answer this time around may be ‘soon.’ And when they do, the market will be sure to tell us.”

Well, the market promptly responded by rising up to a 66th all-time closing high on Friday… and it’s been puking ever since as we head into Friday’s monthly options expiry.

Now, imagine what it will do if the Fed pulls its playbook forward…

Fortune Research Weekly Watchlist: Dec. 14, 2021

For nearly two years, the CBOE Volatility Index, or “the VIX,” has been collapsing. That changed toward the end of last month.

Source: Bloomberg

We just came off a spike into the mid-30 range — which we correctly faded — only to see it make a significantly higher low amid some hedge funds liquidating and others locking in annual gains via the options market.

Source: Barchart

And while clearly some of those puts have been pulled off the board — the chart above is the total put/call ratio — we are not out of the woods yet.

So don’t buy this dip… YET.

Because of this dynamic, I wanted to simplify our Fortune Research weekly watchlist — just two longs and two shorts — and I’ll come back to the longer list next week.

The first long is our old friend the Materials Select Sector SPDR ETF (NYSEArca: XLB), which is up almost 5% since we bought its dip a couple of weeks ago.

The second is the only market that remains in a bullish trend, has fundamentals on its side and has a positive one- and three-month return… the Real Estate Select Sector SPDR ETF (NYSE: XLRE).

If we’re short the broader market, that also means we’re long volatility. So we’re keeping in the iPath Series B S&P 500 VIX Short-Term Futures ETF (NYSEArca: VXX).

And finally, if funds do actually “peace out” from their current holdings after Wednesday’sFed announcement, they’re going to flee to safety. Since we’ve also called the top in inflation, it means it’s time to go LONG bonds, which we do through the iShares 20 Plus Year Treasury Bond ETF (NYSEArca: TLT).

Source: Bloomberg, Fortune Research

Updated weekly watchlist above… stay frosty, everyone.

All the best,

Matt Warder

Fortune Research

WRITTEN BY<br>Matt Warder

Matt Warder

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