How to Play the New Normal: Spiking Volatility

Shah Gilani

Strap on your seat belts...and get ready for a ride...a very bumpy ride.

After having assumed US equities would keep chugging higher with little deviation from "up," things are starting to look a bit different.

Have you been watching Japan? It's a cautionary tale that is about to play out in the US, and globally.

Massive monetary easing in Japan since January tanked 10-year JGB (Japanese government bond) prices and the yield on their 10-year bonds doubled. On top of that, Japanese stocks soared 32%, only to see a series of huge one-day drops and a few smaller-bounce upside rallies.

The volatility has been unprecedented.

The question for investors now is: How do you make money now that the Fed has signaled the beginning of the end of quantitative easing that has stimulated global markets higher?

Here's the first thing you need to know.

Crisis = Danger and Opportunity

Volatility is the new normal, or abnormal, and it's going to be everywhere.

The Federal Reserve, the Dr. Frankenstein of this monster, just hit the master switch to bring that volatility to life.

The Fed took care to build up the markets. It drove the dollar down to hike exports and in the process got some people hired.

It liquefied banks with money by buying their crappy mortgage-backed paper for good old cash...which the banks leveraged to buy more crappy mortgages to sell to the Fed.

Now that's how you trade when you have a backstop! They liquefied the government's mounting deficit problems by buying almost all of its new debt.

To be precise, they didn't buy it directly from the government.

The banks bought it from the government first, then they repo'd (repurchase agreements) those bonds between each other to generate even more short term cash, which they then used to buy more of the government's bills, notes and bonds, which they then sold at marked-up prices to the Fed.

Now that's how you trade when you have a backstop!

So far so good, right? The play by the Fed was to keep interest rates at basically zero for borrowers, not like you, but kind of like the banks, oh yeah, that would be only the banks.

Everyone benefited by super low rates.

Corporations borrowed cheaply to pay down more expensive debt and borrowed still more to buy back their stock to decrease their total number of shares so their earnings per share looked a lot better. Which was all part of the plan to hike stock prices.

The Fed's idea of creating an equity asset bubble was to make the market hit new highs so people got all warm and fuzzy inside and with that wealth effect making them dizzy, they reached into their empty wallets and purses to whip out their credit cards to spend, spend, spend. Why? Because it feels good.

Don't you feel good?

Fed Exit Strategy: Pee in the Punchbowl

But the party had to end sometime. And Thursday was the beginning of the beginning of the end of the party.

Because the dollar was beaten down, other countries had to beat down their currencies (because they need to export too!). We're about to see the residual effects of all that beating down (which ironically was caused by something called stimulus).

We're going to see real currency wars. The first salvos have already been fired. The big guns are eventually going to come out. Welcome to massive currency volatility.

Because interest rates were so low for so long, yield-starved investors clamored for junk bonds that had some decent potential for income. Issuers fell over themselves to supply the demand and hundreds of billions of dollars of junk has been injected into ETFs and CLOs (collateralized loan obligations) and CDOs (collateralized debt obligations) and are now all subject to massive volatility if rates rise and rising rates impact issuers' ability to pay what they owe investors.

Welcome to massive high-yield debt volatility.

Because banks have been so pumped up (kind of like on a cocktail of steroids and creatine) and have to deal with rising rates, they will hold off making loans to consumers because they don't want to get caught lending long at fixed rates when their short-term borrowing costs (which is how they finance their loan books) are rising. Mortgage money will be more expensive.

Welcome to massive volatility in housing...mortgages, home prices and everything to do with housing.

And that's just the beginning.

Where Do Investors Look

So how do you make money in the markets?

Here's what me and my subscribers did, in my Capital Wave Forecast service.

We shorted the Australian dollar (by buying puts on an ETF) because currency wars will necessitate Australia devalues its currency to sell more of their commodities...that trade is up 85%.

We shorted 20-year maturity bonds (by selling puts on an inverse bond ETF), not once but twice. We saw the Capital Wave known as QE-forever rolling over as bond vigilantes began selling the 10-year in spite of the Fed's stimulus, like what happened in Japan...those trades are up 64% and 52%.

We shorted junk bonds (by buying puts on two ETFs: HYG and JNK) because the money chasing yield into junk paper began to topple over...those trades are up 57% and 56%.

And we got into these positions a few weeks ago.

We're also short corn and NASDAQ and looking Frankenstein straight in the eyes.

Oh yeah, we're long gold too. Hey, nobody's perfect. It's the market after all. Fortunately, we're only down 15% on that trade, and we're sticking with it!

So, if you want to make some money in the markets, play all the asset classes, play the volatility, play the new "Abby Normal" (a bow to Mel Brook's Young Frankenstein, which is certainly more entertaining than what we're about to live through).

Shah Gilani

About the Author

Browse Shah's articles | View Shah's research services

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

… Read full bio