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Higher Prices, Lower Volatility

10/25/2007 12:00 am EST


John Bollinger

President and Founder, Bollinger Capital Management

John Bollinger, editor of Capital Growth Letter, says stock prices should move higher in the coming months while volatility will remain elevated before eventually falling again.

Our thesis has been that the August decline and bottom served in the place of the usual fall fireworks and that we ought to be focusing on what is actually happening rather than what is expected to happen.

Misdirection is, of course, the primary job of Mr. Market, who always seeks to sow doubt and engender havoc. Everybody looking for a low in October? Fine, show 'em one in August. Everyone looking for a recession? Fine, just not now. Economy strong? Might just be time for that recession!

Come to think of it, Mr. Market has been working overtime this decade and he has been very effective. Last year we got a May/June decline. This year the declines were in March and August. In 2005 we saw a mild fall pullback after a serous decline that ran from March into April. One can't help but wonder what he has in store for next year.

We expect continuing volatility, with an upside bias. One important reason for this is the dislocation in the real estate market.

Let's step back a moment and see how we got here. By the time 2000 rolled around pretty much everybody believed in stocks. Real estate, bonds, commodities—all that was pretty passé. The name of the game was stocks, stocks, stocks. Then the Internet bubble burst and all those who had quit their day jobs to become traders had an epiphany, "Maybe this isn't so easy after all!"

The Federal Reserve and Treasury provided the liquidity and it was off to the real-estate races, another “sure thing.” Eventually that bubble burst, too, and the question is, "What to do now?" "Retirement looms, so we've got to be investing." And so the cycle starts again.

Looking back we can see that we have shifted into a new volatility regime and we expect that this higher volatility is here for some time to come. We entered the year with the VIX, the CBOE's Volatility Index, at 10, and few could imagine it being anything else.

Now in the wake of the August correction, as the market tries to march into new high territory, the VIX bottomed near 17 and has turned higher again. While early in the year the name of the game was to buy volatility, now it is to sell volatility as opportunities present themselves.

The basic law of the market is that high volatility begets low volatility and vice versa. It is not that people don't know this; it is that they simply cannot imagine how we will get to the other side of the equation. But we do, time and again. For the time being it is not clear that we have reversed the volatility cycle. However there is a reversal pattern in place, and the path of least resistance is toward lower volatility [again].

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