Did the Thanksgiving Rally Start Late, or Did Santa Come Early?

Yesterdays 490-point rally in the Dow Industrials was quite a change of pace
after the worst Thanksgiving Week market since 1932. To say we didnt get a
Turkey Day rally is an understatement. However, yesterday stocks surged as the
Fed, the European Central Bank and other central banks around the world decided
to join forces and inject liquidity into the markets. But will this market
euphoria last, or did we simply get our Santa Rally early (or is this our
Thanksgiving run-up, just a week late)? Trend-following strategists have gotten
chopped up worse than the Philadelphia Eagles pass defense this fall. And most
reversals have come this way, via steep morning gaps. Which of course means that
stops have limited value as protection for overnight positions. The volatility
markets didnt particularly believe in the sell-off last week. The CBOE
Volatility Index (CBOE: VIX ) rallied about 7%, but that was a significant
underperformance with the market drifting nearly 5% especially given that the
VIX has hovered in the low 30s for most of the month of November. The
Thanksgiving Market Slump Might Offer a Preview of December Now, part of that
had to do with the calendar. Option market-makers lower their bids ahead of and
into slow holiday weeks on the (generally correct) assumption that realized
volatility slows. And indeed, realized volatility has slowed. Realized
volatility in the S&P 500 sits near 20, so a VIX near 30 actually overprices
options relative to the pace the market is actually moving now. This whole setup
is not unusual. I ran numbers for my book, Options Volatility Trading (shameless
plug alert!) and found that options in the December cycle are the most
overpriced of the year. I defined this as the relationship of median implied
volatility (basically the VIX) to the median realized volatility of the cycle.
It came out to 1.66, which is pretty close to the ratio were seeing right now.
Can the Markets Make Sense of All This Mayhem? Volatility often picks up in the
fall, and then tapers off into year-end. Options lag a bit in picking this up,
and thus they stay modestly overpriced into year-end. Will it play out that way
this year? We never know of course, but it seems like a plausible setup.
Headline risk remains a factor. As weve seen, the markets just cast their
approval of the latest lifeboat being tossed to the Titanic that is the Eurozone
debt problem, and yet no one is looking at solving the financial problems in the
United States! So, the question is to what extent the market has already priced
in the next events to unfold, whatever they may be. Its possible weve already
discounted them, but only time will tell.