Wall Street Banks on Greek Order, But Volatility Continues to Lurk

 

I have noticed even people who claim everything is predestined, and that we can do nothing to change it, look before they cross the road.”  –Stephen Hawking

 

There is quite a lot in the hopper at the moment for anyone who is attempting to gauge a clear direction the market may be heading. While it may be an impossible task, it will hardly dampen the efforts of millions of investors and traders to figure it all out.

There has been a slight shift in the winds of sentiment over the last two weeks, as Wall Street has seen gains in some of its leading indexes over this time frame. The Dow Jones Industrial Average (DJIA) added 1.7% to its bottom line last week, while the benchmark S&P 500 Index (SPX) gained 1.3%.

The recent uptrend, a marked reversal of the downtrend that played out over the course of the month of May, may be viewed as an indication that investors decided that the Eurozone debt crisis has been baked into the market, at least based on current assumptions. The rise in the euro from recent lows seemed to amplify that perception.

This week offers many tea leaves that can be read and interpreted. The initial results of the Greek elections will probably give investors comfort that Greece will remain in the Eurozone, at least for now. The possibility that the status quo could remain in place will certainly cheer investors, at least until the next jolt of uncertainty re-instills doubt and fear.

Perhaps of equal weight to the equation will be what Ben Bernanke has to say on Wednesday, following a scheduled Fed statement. Nothing will cheer Wall Street more than a clearly articulated promise of further easing, though a simple extension of Operation Twist may fall short of really exciting the market.

Finally, the G-20 summit has at least as much potential of impacting the market as anything else. While Wall Street would certainly applaud expectations of a strong, definitive action, it remains to be seen if such a unified statement could be mustered.

Fragmentation seems to be more the order of the day at the moment. The question is: How much of that has already been baked in to prices of stocks, and is the soufflé ready to rise or collapse?

What the Periscope Sees

Wall Street will likely interpret the results of the weekend election in Greece as a general sign of stability, at least if the initial results prove to hold up. Coupled with the report that the ECB may attempt to step forward and assume a grander role than it has played up until now, investors may decide that the deep problems that permeate the Eurozone are finally being addressed in a comprehensive way, and decide that “risk-on” is a valid option.

However, as has occurred on multiple occasions over the last two years, noble suggestions are made, but then fail to get implemented. And, as the makeup of the Eurozone consists of such a disparate-by-nature group of countries, any necessary consensus required to make the kind of major policy adjustments essential to the euro’s survival may simply be impossible to achieve.

From a trader’s point of view, is there any way to take a position that could generate a profit no matter which way the Eurozone situation unfolds?
There may be, but it would require a pair trade that balances a swift change in sentiment to the upside with the ability to handle a deep drop should current solutions once again be revealed as inadequate.

For your consideration, here is one such pair trade.

Start with EWG (MSCI Germany Index Fund), which tracks the performance of the German equity market. It has gained 3.4% year-to-date (YTD). Compare that to ETFs such as EWP, which tracks the Spanish equity market and is down over 20% YTD, or EWI, which tracks the Italian equity market and is down 10% YTD. None of these numbers should be a surprise, but the point is that using Germany as a basis for the long side of a pair trade may be a better bet than utilizing another ETF that may have more room to rise, but is fundamentally weaker. You want a strong horse in the lead for a good pair trade.

The flip side of the trade would be VXX, which tracks the S&P 500 VIX Short-Term Futures Index. In the event that the Bulls resume control of the market then volatility will drop in accordance, and the VXX, a derivative of the VIX, will drop as well. On the other hand, should investors decide that the outlook for the Eurozone remains on the shaky side, then the VXX should rise steeply, mirroring the next round of uncertainty the VIX would reflect should the latest proposed solutions fail to address the regions problems.

So, for this particular pair trade, one would go long EWG. In addition, the trade requires one to go long VXX as well, which might seem counter-intuitive for a pair trade. However, remember, the VXX, like the VIX, generally goes up as the equity market goes down, and vice versa.

ETF Periscope

 

Full disclosure:  The author does not personally hold any of the ETFs mentioned in this week’s “What the Periscope Sees.”

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Daniel Sckolnik or Sabrient. Neither Daniel Sckolnik nor Sabrient makes any representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.