Thanks for all the responses to Sunday’s post on M2 Volatility and the potential consequences to the markets over the next three years.  A few follow up points based on reader questions:

Q.  Are you advocating shorts instead of longs now? 

A.  No, we are not advocating any positions based on this phenomenon.  #1, Heightened M2 Volatility is not a precise timing signal, only an indication of a probable eventual decline and probable increased volatility in the next three months.  #2, We monitor the markets on a daily basis and will alert if and when we see a top forming.  If equities posted their top yesterday, one day after our report, that would simply be a coincidence.

Q.  Then why issue such a dire warning?

A.  We feel the greatest damage will be done to inexperienced traders and passive investors who only exit the market after experiencing significant losses.  This, in turn, can damage market functionality as money heads elsewhere for a protracted period of time. 

Q.  What is your advice to experienced traders?

A.  We simply recommend giving more weight to distribution days.  Tighter stops may not be feasible because of expected greater-than-normal volatility.  So, selection criteria (for stock pickers) is critical.  For day traders, don’t get caught on the wrong side of the market because we expect ranges to widen.

Q.  Do you see any similarities to the 2001-2002 bear market?

A.  Yes, and unfortunately, it looks much worse now.  The July 20 01 low in M2 Volatility (yellow in the chart below) was a higher low than the previous year, and the higher high in M2 Volatility in the week ending September 21 01 (which coincided with the spike low in the S&P 500) was the end of the broadening wedge in M2 Volatility that began in 1995.  The next year, the three month period following the July 19 02 low in M2 Volatility (which still had a high 12 month range), coincided with the low of the bear market in the week of October 11 02, and M2 Volatility from then on contracted into until about mid-2006.  By mid-2007, it was apparent that M2 Volatility was again increasing, and we had the high in the three month period following July 20 07 (after a steep drop into mid-August 07).   Presently, M2 Volatility is still broadening, making new record highs and new lows.  Though the study by itself did not imply causation, if you believe (as we do) that M2 Volatility causes crashes and is not merely correlated with them, the effect of record M2 Volatility on markets should be greater this year than in any other going back to inception of weekly M2 data in 1981.

10:44 am EDT:  ES is testing yesterday’s lows after a worse than expected Consumer Confidence report.  We’re willing to short between 975 and 977, but if the ES cannot get back above 973.25 soon, we could easily head down to the next support area of 962.75 to 965.25, at which we would fade long with tight stops.  We’re not outright bullish until the ES can again get above 980, which we think is unlikely today.  Watch price action around the 1:00 pm Treasury auctions because a disaster (unlikely) would be enough to turn equities bullish.

Gold materially down from resistance and 30 yr/10 yr holding support today give a bearish tilt to the market’s direction this week and are forecasting successful Treasury auctions.  Also, the EuroYen forex cross, as a barometer of risk, has also materially corrected today in a bearish engulfing candlestick pattern. 

Accordingly, the most likely scenario this week that we envision is a down day today, up day tomorrow into the close because of POMO, retest of highs either by end of tomorrow or early Thursday, then heading down again into Friday close, with the markets attempting to find support and continue the rally sometime next week.  If we can reach new highs by early Thursday, then we could easily see another short covering rally into the 1008 target zone by Friday close; however, this is the less likely scenario.

Another thing we’ll be watching today is the shaded light gray box under the current price.  The dotted green line (std dev 1 of VWAP anchored from July 13 09) has contained the ES pretty well since the start of this mini rally and a material breach would likely signal that a correction will finally get underway.

The Precise Take – Slight weakness into significant Treasury auction day

The short term and TIPS Treasury auctions went well as expected yesterday, with the first test of the real demand for medium term Treasuries today at 1:00 pm with the 52 Week and 2 Year auctions.  We’re still looking for leadership clues with gold trying to break through 61.8% resistance or reverse to the downside off this level, and similarly a break in 10 year notes and 30 year bonds of support or a reversal to the upside, with none of the three moving materially since yesterday.

Tomorrow and Thursday of this week are back to back days in which the Federal Reserve Bank of New York (FRNY) will be conducting permanent open market operations (POMO)*, which will flood large banks with leveragable liquidity at about 11:00 am on each of those days, and which has an end of day tape-painting effect.  See page two for time profile graphs of what can statistically be expected for today, tomorrow and Thursday.  There is a tendency on a Pre POMO day, such as today, to front run the expected liquidity injection into the close (3:30 pm to 4:15 pm).  Tomorrow, we would also expect most gains to be into the close.  And, though there have been only 6 prior back to back POMO days (all since May), the bullish edge appears to disappear on the second POMO day, which would be this Thursday.  Accordingly, swing longs may want to close out positions by tomorrow (Wed) as opposed to waiting for the close on Thursday.

Today is a moderately full news day with the times to watch as 9:00 am, 10:00 am and 1:00 pm.  With premarket action in the ES getting down to daily S1 (day-session-only) and below yesterday’s highest value area point of control, we have a bearish bias.  Longs will need to get above the daily pivot/gap area of 976.25 to 980.00 to regain…

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