While the selloff may mark the end of a lengthy rally to new highs, it definitively ended another record setting run. Over the prior 40 trading days, the S&P 500 had been stuck within a range of 1.75% from its high to its low. This was the longest period of this limited volatility in the history of the market. Don’t expect it to continue.

The above chart shows the VIX, more formally known as the Volatility Index. As you can see, the VIX has been trading at rock bottom levels recently; not surprising considering the lack of volatility in the market. But, what exactly does it mean when the VIX is trading at a low?

The volatility index is, according to its sponsor, the CBOE, a “measure of market expectations of volatility conveyed by option prices. The index measures the market's expectation of volatility implicit in the prices of options.” So, the VIX trading at low levels means that options traders don’t expect significant movements in underlying securities. This includes not only individual stocks, but indexes such as the S&P and the NASDAQ.

The problem with the VIX, and what creates opportunity for investors, is that it is incredibly rear-view mirror in its pricing. Just look at the chart. A month before entering the longest period of minimal volatility in history, the VIX soared to over $20 on Brexit concerns. (As an aside, this increase in the VIX on a global macro scare such as Brexit is quite common and is how the index got its nickname as the “Fear Index”)

Looking at the VIX today, and I really wish the selloff could have waited until Monday when this had been published already, it’s bumping along at all-time low levels. And, we are entering what is historically the worst month for stocks plus an important election. All this portends increased market anxiety and a possible selloff.

Increased market anxiety would be an obvious benefit for the VIX. Nervous investors tend to have itchy trigger fingers and this causes liquidity to dry up and volatility to increase. However, just as important to the volatility index is a market selloff. Even if it’s orderly, a down market creates a higher VIX than an up market. This is because traders try to hedge themselves against losing money by buying options. No one hedges against making money.

So, we’re bumping along at all-time lows on the VIX here in early September. Traders seem to be very resigned to dead markets and everyone thinks the central banks will step in to any market selloff with buying support. Thus, what could cause the volatility index to go up from here? I see several possible causes, starting with the election, and Donald Trump in particular, as the primary one.

There are several reasons why the election is important for volatility and the market. These are especially pertinent as we enter September. The first is that the 8th year of a presidents’ tenure tends to be a down year; 1.2% on average. We have been trading higher this year, but there’s a reason why this is historically a weak year and, entering the weakest month of the year, maybe it catches up with us.

Secondly, according to NASDAQ, “volatility tends to develop in the first year following an election, as the market digests change.” We are getting closer to the election. I would expect to see volatility increase, as it always does, post the election.

Thirdly, as relates to Mr. Trump, he is getting stronger in the polls. Now, there is (in my opinion) reason to fear him, but I won’t bring politics into this newsletter. What I will do is quote NASDAQ again.

“A rise in the index between July and October of an election year has predicted reelection of the incumbent candidate or party, while the reverse has pointed to a replacement.”

Thus, as The Donald gets stronger in the polls, one would expect to see a selloff, which would lead to a higher VIX. Perhaps Friday’s action portends Trump catching Hillary? Time will tell.

Beyond the election, there are many other potential catalysts for increased volatility. These range from weaker earnings to increased odds of a rate hike and even North Korea increasing its shenanigans. Which, I think will happen. Does anyone else think that every anti-US country wants to see Trump elected? He’s kowtowing to Putin and I could easily see him applauding the Korean dictator’s leadership skills. The cabinet meetings there already resemble The Apprentice, only “You’re fired!” has turned into a "Firing squad!"

I see a case for a much higher VIX in the near future. As such, investors have several ways to prepare themselves for this. There are several ways to trade the VIX, and here’s a link for those who want to explore them. The most obvious method, and what I like to do, is buying options on the VIX itself. But, this is certainly out the risk curve and for professional traders only.

The bottom line here is that, as we enter the weakest month of the year, and come upon an election that is going to be very ugly and volatile, one would expect the market to start to react. We have just ended the longest stretch of limited volatility in the history of the market. Investors should expect to see increased volatility going forward and should prepare themselves for this now.

Random Musings From Our Travels

"Put your feet flat on the floor. Listen to your breath. Close your eyes. Hear the sounds around you, but focus on your breath." What the heck? Am I in yoga class?

Last night, at "college night for parents", the college advisor led us through how he starts each group session with the seniors. The breathing and relaxation exercise is meant to eliminate some of the stress that goes along with the college application process. After all, as he says, "these kids are facing rejection for the first time in their lives".

There's a lot of irony in that statement. Because, since we're at a private school, and since our daughter didn't get into her first choice of schools, we already dealt with school rejection. And, had a Thatcher hat burning in the fireplace to celebrate that...but, I digress. Back to the breathing.

Meanwhile, not focusing on her breathing, Joan is poking me, thinking that I'm likely on the verge of laughing at the stupid breathing exercise. She couldn't have been more wrong. Just keep calm, breath smoothly and don't look at the chart below...

No, I wasn't close to laughing. Instead, I was thinking that the breathing technique might come in handy every August when the tuition bill comes.