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.