A comedown may be waiting after Fed high

NEW YORK (Reuters): Comparing the Federal Reserve to a rehab clinic offering addicted investors a synthetic high has been a favorite of Wall Street wags ever since the first round of Fed stimulus nearly four years ago. The punch line is that you always need more and more to get the same high and each bout of euphoria is followed by a crashing comedown.

After the frenetic reaction brought about by the announcement of the Fed’s latest stimulus program - $40 billion pumped into the U.S. economy each month - the coming week is likely to bring a more sober period for markets as investors digest what it means in the longer run and turn their attention to the remainder of the year.

That will include rancorous U.S. elections in November, wrangling over taxes and spending cuts and a slowdown in corporate earnings.

“Right now we have this short-term euphoria. But then the question is where do we go from here,” said Frank Fantozzi, chief executive of Planned Financial Services, an independent wealth manager in Cleveland. “I think after a week or so, if the underlying economic data doesn’t change, you’re going to see the market drop a bit and we’ll continue to plod along until the election.”

The effect on markets of the European Central Bank’s plan to buy government bonds of struggling euro zone countries, then the Fed’s opened-ended commitment to spur growth have been breathtaking. The Dow and the S&P 500 reached the highest closing level in nearly five years while the Nasdaq marched to new 12-year highs.

Heady territory

But in Friday’s stock market action strong gains in the morning steadily eroded throughout the day, perhaps the first signs of fatigue creeping into the market.

“We are starting to get into that heady territory where you need to be on the defensive,” said Richard Ross, global technical strategist at Aubach Grayson in New York. “Trying to squeak out the last 5 percent of a move when there is potentially a 15 to 20 percent downside in my opinion is pretty dangerous stuff.”

Ross believes that equities, commodities and currencies are now approaching extreme levels of both price and momentum while geopolitical tensions in the Middle East are rising.

Even though all the major stock market rallies since the financial crisis have coincided with new central bank efforts to stimulate the economy, not everyone is buying it.

The latest data shows a moderate increase in short interest - bets that stocks will fall - across S&P 500 stocks during the last two weeks of August, a period when stocks were rallying on expectations of the Fed’s announcement. Typically short interest inversely tracks the market. If investors were getting out of bets that stocks will fall, that would mean buying back those stocks and forcing the market higher.

Data provided by Schaeffer’s Investment Research, a Cincinnati-based research firm, shows that bets against the biggest 500 U.S. companies edged back to about 7.3 billion shares after falling from about 7.6 billion to 7.2 billion from the start of July through the end of August - a period when the market gained more than 3 percent.

Reduce volatility

That uptick in short interest could be significant. From the middle of September 2011 through the end of May this year, short interest on S&P 500 stocks fell like a stone to about 6 billion shares. During that period the S&P hit a four-year high, rising more than 20 percent from trough to peak.

One side effect of the Fed’s bond-buying should be to reduce volatility in markets. That means the CBOE VIX volatility index .VIX should remain close to the five-year lows it hit this summer. In August it fell as low as 13.30.

Yet activity in the options market shows some very bold bets that volatility could sky rocket in the months ahead. Call option buying on the VIX - bets the index will rise - is close to a record high at 5.182 million contracts, according to Schaeffer’s data. The record is 5.249 million set in August.

The most actively traded VIX calls on the Chicago Board Options Exchange were October calls with a strike price of 60. Those also had the highest open interest. The VIX would need to rocket more than 300 percent by mid-October, hitting its highest level in about four years, for that trade to break even.

On the face of it a bet like that may seem little better than betting your 401(k) on a single number on the roulette table, but it does reveal more bearishness creeping into the market as stock indexes march to new highs.

Open interest, or outstanding contracts, on the October VIX calls with a strike price of 60 was 37,000 while traded volume was around 40,000. Many of those were bought in blocks of 2000 to 5000 for 5 cents each, suggesting a single buyer, according to Todd Salamone, vice president of research at Schaeffer’s.

“Somebody’s really playing a disaster by October,” said Salamone. “If they’re looking for something that big, that is not a portfolio hedge because that would be a lot of downside in the market before that hedge would actually kick in.”