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What Could Cause The Stock Market Rally To End and Volatility To Return

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What Could Cause The Stock Market Rally To End and Volatility To Return

Stock Market Rally To EndWith the Standard and Poors 500 (S&P 500) index and Dow Jones Industrial Average at all time record highs, and volatility at multi-decade lows, many traders and investors are wondering what could cause the stock market rally to end and volatility to return?  There are a number of developments that could cause the stock market rally to end and volatility to spike higher, some of which are obvious, while others not so obvious.  There are also black swan events that come out of nowhere and bring bull market runs to an end, with an accompanying spike in volatility.  While letting fear rule one’s trading and investment strategy is a bad idea, it is a good idea to at least be aware of the risks that the bull market faces, so that if any come to fruition, you are prepared to act.

With the Price to Earnings ratio (P/E ratio) of S&P 500 index stocks in the overvalued 19 range (well above the long-term S&P 500 index P/E ratio average of approximately 15), any negative surprises could send the stock market reeling lower by 10% or more, as investors revaluate their outlook for corporate earnings and stock prices going forward.

Developments That Could Cause The Stock Market Rally To End and Volatility To Return

Stock Market Rally End

One of the most obvious reasons why a stock market rally ends is the economy falls into a recession, which impacts corporate earnings and subsequently stock valuations and prices.  However, that is not the primary concern at the moment.  Even though the United States economy surprised many with a 2.9% Gross Domestic Product (GDP) contraction during the first quarter of 2014, everyone has written that off as weather related.  The economic data in the spring and early summer of 2014 are indicating a return to growth during the remainder of 2014.  The consensus amongst economists is for at latest three percent GDP growth throughout the second half of 2014.

While economic growth is not currently a threat to the stock market rally, there are other developments that may occur during the remainder of 2014 that could cause the bull market to end and volatility to increase.

Perhaps the most predictable threat to the bull market rally is increasing indications from the Federal Reserve about a pending rise in interest rates during 2015.  While stocks can do well for years in a rising interest rate environment, eventually interest rates reach a level in which they choke off economic growth and cause investors to seek safer fixed-price investments and sell stocks.  In a normal economic environment, the start of the Federal Reserve’s interest rate raising cycle would not be of much concern to the stock market; however, coming off of nearly six years of a Federal Reserve target rate near zero and multi-decade lows in interest rates throughout the economy, there are reasons to be concerned about how the start of the Federal Reserve’s interest rate raising cycle may impact stock prices this time around.

While more transitory in nature, national politics in Washington, DC could once again cause investors to head for safety and sell stocks.  With partisan lines hardening in Washington after the 2014 primary election results, the potential for another manufactured budget crisis looms as a potential bull market slayer, as Congress debates a new budget for the 2015 fiscal year that starts on October 1st, 2014.

The final factor that might bring an end to the stock market rally and cause volatility to rise is a wide array of geopolitical events, some identifiable and some currently either unknown or not well understood.  If the civil war in Iraq were to grow, it could affect oil supplies and cause oil prices to spike higher, causing the economy and stock market to falter.  Another potentially disruptive Middle East conflict would be an attack on Iran’s nuclear facilities, which could cause a wider war and energy supply disruptions.  The situation in Ukraine appears to have settled down, but any additional moves by Russia to take over pieces of neighboring countries could cause spikes in energy prices and have a negative impact on the stock market and economy.  There are also the ongoing risks of renewed debt and banking problems in Europe.

Of course, it is the unknown events that usually cause the stock market to experience its sharpest sell-offs, with an accompanying spike in volatility.  These events are called ‘black swans” because they come out of nowhere and surprise the investment community.  Potential black swan events could include a large terrorist attack on Western interests or oil supply facilities, or something along the lines of political upheaval in China.  Nobody knows until they happen.

How To Trade The End of the Stock Market Rally and Increased Volatility

Profit As Market DeclinesThe good news for traders is that the end of the stock market rally does not mean the end of money making opportunities in the stock market.  There are many ways to profit from a downwards move in the stock market and increased volatility that accompanies a stock market sell-off.  For long-term investors, any such sell-off, while not tradable, could provide an excellent opportunity to put money to work in the stock market for long-term investment goals.

Securities that can be purchased that go up in value as the market falls include and Exchange Traded Fund (ETF) Direxion Daily Small Cap Bear 3X Shares (NYSE:  TZA).  This ETF is designed to move at a ratio that is three the opposite direction of the Russell 2000 small capitalization stock index.

ProShares Short S&P500 (NYSE:  SH) is an ETF that attempts to replicate the inverse of the daily performance of the S&P 500 index.  If the S&P 500 is down 2%, then SH should be up approximately 2%.

ProShares UltraShort S&P500 (NYSE:  SDS) is an ETF that attempts to replicate twice (two times) the inverse of the daily performance of the S&P 500 index.  If the S&P 500 is down 2%, then SDS should be up approximately 4%.

To trade stock market volatility, there are a number of products that can be used, such as VelocityShares Daily 2x VIX ST ETN (NYSE: TVIX), which is designed to track near-term Volatility Index (VIX) futures contracts at a two times their movement.  Therefore, if near-term VIX futures contracts spike 30%, due to a steep stock market sell-off, TVIX should theoretically be up 60%.

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