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Yesterday, in the Hedgeye Daily Outlook, our risk management call out was to watch the VIX.  In it, I advised that “the VIX is going to blowout into bullish long term TAIL if it closes > 22.03; that’s not something you want to mess with if it holds.”  Since the close on Monday, the VIX is up 23.3%, trading comfortable above 22.03.

Looking the chart below, it is clear that the VIX could still go a lot higher from here.  Last year, during the peak of the Sovereign debt crisis, the VIX traded at 45.79.  The average of the peak VIX levels during the past 6 major crises that impacted global financial markets comes to approximately 50, which would represent 48% upside from here.

As we always say, risk is always on.  Clearly, events in Japan are tragic and deeply saddening.  However, the systemic risks in Japan from an investment perspective remain: demographic headwinds and staggering government debt being the most prevalent.  These risks will not go away and, if anything, the unfortunate severity of the earthquake, tsunami, and ensuing (and continuing) radiation crisis will likely increase uncertainty and heighten concerns about economic growth from here.  Furthermore, the government’s handling of the crisis is being heavily criticized, as is evident by the trend on twitter from Japanese people ordering Prime Minister Kan to wake up: #han_okiro.  Tellingly, yesterday, some users were switching to #kan_netero, meaning “Kan, stay in bed”.

The media is currently focused on Japan.  As is tradition, mainstream media likes to focus on one thing at a time.  As events in Japan continue to captivate viewers of the most prevalent news sources, the unrest in the Middle East continues.  The uncertainty that this wave of political agitation can bring to global markets, particularly those most closely tied to oil, is likely to cause significant volatility if regimes continue to fall.  Footage of unarmed civilians being shot at point blank range by Bahraini military forces speaks to the gravity of the situation in Bahrain at present.

Another small island country, Ireland, is also worth monitoring from a risk management perspective.  A tiny economy by comparison to the larger EU, Ireland’s economy is heavily burdened by a debt-laden financial sector that was 100% guaranteed by the country’s last government.  At present, the new Irish Taoiseach, or Prime Minister, is refusing to budge on EU demands to raise its corporate tax rate from its current level of 12.5% towards the European average of 23%.  As a result, Ireland is being denied its request for a reduction in the interest rate on its bailout loan from the EU/IMF.   Given the contentious nature of this issue, and the fact that a failure to reach resolution could spur contagion in the Euro zone, it is worth monitoring closely.  Our Macro conviction is that the EU is likely to kick the can down the road as debt ratios go higher and higher.  Markets applauded the European debt crisis package on Monday, to a degree, but Ireland is systemically important part of Europe’s sovereign debt conundrum and the situation could deteriorate if the current impasse between Dublin and Brussels persists.

Clearly, risk is always “on”, whether or not the media is focused on them at this particular moment.  The recent downgrades of Portugal and Spain by Moody’s remind us of this.  As the current crisis in Japan intensifies, questions mount as to whether or not the FED suggested yesterday that QE3 will not be needed, inflation accelerates, global growth slows (downward GDP revisions),  and the Euro-zone debt crisis looms large in the background, a melt up in volatility could be just around the corner.

The VIX is immediate-term overbought.  Over the intermediate term, we have the range for the VIX getting as high as $35 or $40.

Howard Penney

Managing Director

THE VIX REVISITED - shawshank