State Budgets, the VIX, and the Stock Market

On the surface, the stock market looks OK - going up slowly but surely, with the Dow closing in on the 12,000 mark. I'm a little wary because this week the Volatility Index (also known as the VIX), went up from 15.5 to 18.5 - about 20% from Tuesday through Friday.

There's an old saying when it comes to the VIX: "When it's high, you buy - when it's low, you go (sell)." It's been low and dormant for a long time, but it looks like it's waking from its slumber... and ready to go much higher.

I don't see ANY fundamentals holding the stock market up at current levels, other than High-Frequency Trading from investment banks and maybe some help from the Fed. State budgets around the country are bleeding red ink from deficits and debt - and in Illinois, their only remedy seems to be a financial transfusion of money from taxpayers.

When the New York Times runs a story about states looking to possibly file bankruptcy, the economy is not as rosy as economists like Brian Wesbury would have you believe.

Just like in 2007 when the Dow reached its peak of over 14,000, that didn't mean the economy was fundamentally sound. It was heavily laden with debt, and at the climax of the biggest misallocation of money in the history of the world. The biggest problem I have with Wesbury's hypothesis is that because Republicans have control of the House of Representatives, this will magically improve the economy.

I want to be optimistic about the overall American economy, but when I look at the mountains of debt at the federal, state, corporate and household levels, I seriously doubt we'll ever repay these obligations. Default is the more likely option for municipal bonds and defined-benefit pension plans. Until these debts are paid back or defaulted upon, we won't see Honest-to-Pete savings and investment for a very long time.

And I don't believe that enough Republicans in Washington (or most state capitols) have the gumption to make the necessary cuts. Almost all politicians care about what's best for them, and getting re-elected. If they make these needed cuts, they'll piss off a key campaign donor or special-interest group... and they can kiss their office goodbye. So they'll tinker around the edges, and find solutions that will try to "kick the can" down the road and further postpone the day of financial reckoning.

What does this all mean for the stock market? Unless the investment banks and powers that be can keep levitating the market at current levels, I believe it's headed for another leg down. State pension funds will sell the most liquid assets in their portfolio (probably stocks and mutual funds) to shore up deficits, and keep making payments in the short-term.

I do see opportunities for short-term traders who are nimble enough to get in and get out of the markets, and take their profits. And a few for long-term investors who know the right industries and companies to pick. But over that long-term horizon, we could see a roller-coaster ride of volatility that could shake you to your core.

If you still want to invest in the stock market, you need to have a high risk tolerance... strict money management rules in place... and stick to those rules consistently. Tray tables and seats in the locked and upright position, folks - it's gonna be an interesting ride.