 No Fear in Stocks 2
Adam Hamilton
Archives
January 14, 2005
The behavior of the US stock markets in recent months has been
utterly fascinating. From the market-igniting presidential elections
a couple months ago to the anomalous January weakness plaguing
the markets now, strange things are definitely afoot.
To set the stage to investigate
we first have to peer back into 2004. In the entire year until
Election Day on November 2nd, the S&P 500 was up just under
1.7%. After topping early in the year, the markets were actually
in a distinct downtrend until just before the elections
when the bulls started stampeding.
But from Election Day until
the end of the year, the S&P 500 exhibited stupendous performance
and rallied another 7.2%. Fully 4/5ths of the gains for
the entire year accrued in the last two months of trading after
the election uncertainties finally evaporated! This strong and
impressive election rally has led to today's environment where
there is no fear in the stock markets.
In the first week of this year
however, the S&P 500 actually fell 2.1%, a rather
odd event. In a single week not only were nearly a third of the
election rally's gains stripped away, but the stock-market performance
in the first week of the year is considered to be a key metric
for one variation of the popular January Effect. As goes the
first week, so goes the year per this particular barometer.
So we had a 2004 that was trending
relentlessly to a negative finish for its first ten months, then
a powerful rally on an exogenous event that cannot be repeated
for four years, and then a rare down first week in 2005 when
fresh new pension capital usually deluges into the markets and
boosts stock prices significantly. In light of these events I
would think caution should be in order. A two-month election
rally does not necessarily nullify a ten-month downtrend.
But, since stock investors
as a herd have an attention span shorter than most five-year
olds, the election rally has colored today's sentiment to a dazzling
degree. The tyranny of the present is a constant threat to rational
thought and adequate consideration of longer-term context. Per
the popular volatility indexes that are the most widely respected
sentiment gauges, there is literally no fear in the US
stock markets today.
The famous S&P 500 VIX
fell to a phenomenal decade low in late December. Its
younger sibling the NASDAQ 100 VXN hit an all-time low
the same week. For whatever reason, the majority of investors
expect nothing but clean sailing ahead and aren't the least bit
concerned that markets can move down even easier than they can
move up. Complacency reigns supreme today, a very dangerous development.
As a contrarian speculator
who monitors these things continuously, the extremely low fear
levels today strike me with an unmistakable ring of déjà
vu. In fact, a year ago this week I was writing my original "No Fear in Stocks"
essay discussing the same unnaturally low fear levels per the
volatility indexes. Only last year the VIX and VXN lows to date
were 38% higher and 32% higher respectively, far
less extreme than today's lows in retrospect.
This week I would like to update
this volatility-index no-fear analysis, discussing the events
of 2004 that led to today and what this may portend for 2005
in the major US equity markets. Anomalously extreme sentiment
readings can only be ignored with great peril, and investors
ought to take such rare developments very seriously.
In this chart the real technical
nature of 2004 for the US stock markets is painfully apparent.
Until just before the elections, the S&P 500, the best proxy
for the markets in general, was grinding relentlessly lower in
a crystal-clear downtrend. It bounced in a relatively narrow
band between support and resistance, carving a series of lower
highs and lower lows. It even fell below its key 200-day moving
average, an early sign of stubbornly persistent technical weakness.
Thus, prior to the sharp election
rally, 2004 was unfolding in an unmistakably bearish manner.
You wouldn't know it from listening to the hyper-bullish general
sentiment today though. When bullish mainstream investors talk
about the markets these days, for the most part they can't seem
to see much beyond the last couple months. The most recent short-term
past, as always, has colored today's prevailing sentiment tremendously.
Meanwhile the VIX trended lower
as well in 2004, also carving a narrow downtrend channel ultimately
culminating in its decade low just above 11 in late December.
This VIX behavior remains quite peculiar though. Usually the
VIX moves opposite to the markets, as it did throughout
2001, 2002, and 2003. Yet it spent the first 10 months of 2004
trending lower right along with the stock markets.
The volatility indexes usually
move contrary to the markets because they are sentiment gauges.
A low VIX like today's means there is very low fear and very
high greed or complacency, a herd psychological state only reached
after a major rally. The higher the stock markets run, the lower
fear gets. Investors tend to make linear assumptions with just
the most recent data, they extrapolate the latest trend out into
infinity and therefore wrongly become the most bullish right
at major interim tops.
Conversely a high VIX means
high fear and very low greed or complacency. Such fear-laden
events only happen after major market drops, like the vicious
series of V-bounces in the markets from 2000 to late 2002 rendered
above. The lower the stock markets plummet, the higher fear mushrooms.
And once again, since so few people have trained themselves to
think as contrarians, fear is always greatest at a major bottom,
exactly the wrong time.
So it is pretty odd for the
markets to grind lower while fear falls with them, exactly the
anomalous course of action for the first ten months of 2004.
Even with a nearly year-long downtrend and a 200-day moving average
support failure, last year investors just weren't the least bit
worried. I suspect the elections had a lot to do with it. Investors
assumed the markets were weak because of election uncertainty,
and they were willing to accept this thesis at face value without
further exploration or worry.
Now we are faced with an interesting
situation where the markets are a bit higher this January than
last January thanks to the election rally. But the already low
implied volatility readings of last year have plunged off a cliff.
Following last year's low volatility extremes, the markets grinded
lower just as they should have. Is there any reason to think
today's even more anomalous volatility lows will somehow shock
and lead to a bullish outcome? I really doubt it.
Whenever I write about extreme
VIX lows, I understandably receive a blizzard of e-mails pointing
out that volatility was extremely low in the mid-1990s too, just
before the spectacularly bullish last stage of the Great Bull
that launched back in 1982. If the S&P 500 was able to rally
off extreme VIX lows then why can't it do it again today? My
answer is it certainly could, because anything can happen
in the markets at any time, but I believe the probabilities argue
strongly against it. The primary reason is the Long Valuation
Waves.
Stock markets tend to move
in great cycles running a third
of a century or so each. These are driven by valuations.
Stocks start cheap (1982), gradually become more expensive (1982-1999),
hit a spectacular blow-off top (2000), and then their valuations
decay until they reach undervalued lows again (2000-20XX) and
the cycle begins anew like a phoenix. I have written extensively
about these Long
Valuation Waves and their immensely powerful mean
reversions if you are unfamiliar with these important strategic
cycles.
The mid-1990s VIX lows happened
during the first half of a Long Valuation Wave when valuations
were generally rising. Pretty much everything is bullish in the
ascent phase of a valuation wave, as investors are in the process
of bidding up valuations to high levels. Today though, since
March 2000, we are now in the descent phase of this valuation
wave. Today valuations are gradually sinking, either via stock
prices falling to match earnings or earnings gradually
rising to meet stock prices.
Expecting an extreme VIX low
to be bullish in the latter half of our Long Valuation Wave,
the descent phase, is not a very prudent bet. Valuation seasons
must be considered in long-term sentiment interpretations,
as a weather analogy illustrates.
In both March and September
in the northern US, gorgeous sunny 60-degree days are witnessed.
Even though the days may be identical, the March day portends
higher summer temperatures coming while the September day warns
of lower winter temperatures approaching. Would it be wise to
see a 60-degree day in September, remember the similar glorious
March day, and assume that because the September day was like
the March day that summer would be coming again in November and
December while winter was totally skipped? Of course not!
The current valuation season
matters tremendously for anticipating stock trends just as real
seasons matter for predicting temperatures. The mid-1990s VIX
lows occurred as valuation summer was approaching, the peak point
of the current Long Valuation Wave. Today's VIX lows are occurring
as valuation winter is approaching, the low point of the valuation
cycle. Thus I think it is not prudent to interpret today's VIX
lows in the same light as those of a decade ago.
Speaking of valuations, last
January Wall Street's main argument in favor of ignoring the
extremely low prevailing fear levels at the time was that US
corporate earnings would rocket higher in 2004 to justify the
historically high valuations. They argued that, while stock prices
were certainly expensive in early 2004, they wouldn't seem high
by 2005 once earnings exploded. Were they right?
As 2004 dawned, the S&P
500 was trading at 27.7x earnings. This is incredibly high in
light of history, where the average valuation over more than
a century has been 14x.
In fact, once above 28x a market is officially a bubble, so the
S&P 500 was perilously close to that dubious honor a year
ago. It was also only yielding 1.6% in dividends at the time,
extremely low by historical standards. Just as January 2004's
low VIX telegraphed, the markets were dangerously overvalued
by any rational measure.
Today as 2005 is born, the
S&P 500 valuations have indeed moderated a bit as Wall Street
predicted. The index was down to 23.2x earnings, significantly
lower than last year but still far above 14x fair value or the
dismal sub-10x levels seen at Long Valuation Wave troughs every
third of a century or so. The S&P 500's dividend yield barely
budged to 1.7% today, pretty ironic since Wall Street predicted
the dividend tax reductions would lead to a massive surge in
cash dividends.
Today's decade-low implied
volatility readings warning of extraordinary complacency coincide
with a stock market that is still very expensive historically.
And all this is happening in the descent phase of a Long Valuation
Wave. Corporate earnings are indeed gradually rising, but they
haven't risen anywhere near fast enough to justify the war rally
since early 2003 or even the smaller election rally of late 2004.
Highly overvalued markets combined
with extremely low fear are a recipe for disaster, as history
has proven so many times before. If you are long the mainstream
stock markets via significant direct investment or pension capital,
you are betting against the entire weight of market history.
Extreme VIX lows combined with very expensive earnings multiples
are breeding grounds for bear markets, not spectacular
new bulls. Please be careful here and realize the immense risks
involved!
Today's no-fear environment
glaringly evident in the flagship S&P 500 is still more pronounced
in the hyper-bullish NASDAQ and its NASDAQ 100 VXN implied volatility
index. The parallels between the chart above and this NASDAQ
one really highlight the broad systemic danger here from zero
fear combined with stellar valuations.
The market-darling NASDAQ's
chart echoes the broader S&P 500's above, but with even more
extremes. The 2004 downtrend prior to the election was even more
pronounced in the remnants of the 1999 speculative mania. In
2004 to Election Day, the NASDAQ was actually down 1%
on the year! But from the elections to year end, the index was
up 10% making all of its gains in only the last two months.
Once again an exogenous event not repeatable for four years has
led to the questionable conclusion that 2004 was a good year
for tech stocks.
Tech investors are so exuberant
today that they have driven the VXN NASDAQ 100 implied volatility
index to all-time lows. Granted, the VXN was only introduced
in 2001 so it doesn't have the fabled multi-decade history of
the VIX, but its current lows are still extreme. No fear is to
be found anywhere in tech stock land as far as I can tell. And
the immense prevailing complacency is combined with even more
outrageous valuations, not a bullish sign.
One of the greatest lessons
from the NASDAQ bust was that valuations matter. If
you choose to buy an excessively expensive stock, you are virtually
assured to lose money in the long term, period. At the end of
2004 just as complacency was waxing the highest though, NASDAQ
valuations were staggering collectively and individually. As
2005 dawned the NASDAQ 100 was trading at a maniacal 42.2x earnings,
far above the 28x bubble level. And it was only yielding a laughable
0.4% in dividends, even lower than the dismal anti-saver US interest
rates.
Meanwhile all of the 10 largest
stocks of the NASDAQ had individual valuations running from expensive
to crazy. YHOO was trading at 99.7x earnings, EBAY at 110.2x,
MSFT at 36.0x, AMGN at 38.2x, and DELL at 34.8x. These valuations
are starting to remind me of the madness we saw in 1999, where
investors were willing to pay so much for a stock that it would
have taken the underlying company over 100 years just
to earn back in profits the price they paid for the stock!
The NASDAQ faithful always
scoff at the notion of valuations and sentiment actually meaning
anything in their market because it is a "growth market."
This defense is weak though. The biggest and most important NASDAQ
stocks like MSFT and INTC are now mature companies that just
don't ramp earnings like small growth stocks anymore. For example,
neither of these two largest NASDAQ companies have any exciting
new major products coming to market in 2005. In both cases they
are merely eking out modest incremental improvements in their
products and hoping that replacement computer and software demand
will drive their bottom lines. Growth stocks they ain't!
Most of the largest and heaviest-weighted
NASDAQ companies are like this, maturing without exceptional
growth prospects. And later this year they will have to start
expensing employee stock options too, dramatically slashing their
reported earnings in some cases. The NASDAQ may have been a growth-stock
market in the early 1990s, but it is generally not today. By
market-cap it is primarily the home of large mature tech companies
that have virtually no chance of growing profits fast enough
to justify their staggering valuations.
And this brings us full circle.
Whether in the broad markets or the market-darling tech sector,
why are investors so overly confident today? Why have they driven
fear to near-record or record lows and why are they so smug and
complacent that 2005 is going to be a spectacularly bullish year
with trivial downside risk? Do sentiment and valuations still
matter or not?
I am certain they do
still matter. From a contrarian perspective, the two most dangerous
times to be long the markets are first of all when sentiment
is extremely greedy and complacent and second when valuations
are very high. Both major warning signs coexist today.
The time the markets are most likely to fall is when the fewest
people expect it.
As Warren Buffett has wisely
said, the five most dangerous words any investor can ever utter
are "This Time It Is Different." Investors betting
on a massive new bull-market upleg launching today when there
is no fear and valuations are obnoxiously high are declaring
that this time it is different, that we are in a brave
new era where the centuries-old laws of the markets no longer
apply. This is the same cavalier attitude that led to the NASDAQ
crash of 2000.
As a contrarian speculator,
I will side with the weight of history over an unprecedented
new era every time. I am carefully watching the VIX and VXN downtrends
shown above and waiting for a breakout to signal a potential
major new downleg brewing. Once these volatility indices break
above their respective resistance lines the sky is the limit
and we may once again taste what true fear is like in general
equities.
We are looking to deploy index
puts when appropriate, and I will recommend them when I make
the trades in our acclaimed monthly newsletter. Our subscribers
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custom dual-axis sentiment charts updated weekly that we use
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The bottom line is there is
no fear in stocks today. Sentiment readings are at extremely
complacent levels not even witnessed at the great bubble top
of 2000 in some cases. Heck, even traditionally contrarian web
forums are getting sucked up into the insidious bullishness pervading
the markets thanks to the recent election rally. You have to
be pretty heretical to even admit that there is a possibility
for an ugly 2005 these days.
Yet, the markets are remarkably
consistent in punishing investors in history for thinking like
herds. Stocks tend to bottom just as folks are the most terrified
and selling like crazy, and they tend to top just when people
become so comfortable and complacent that they can't even conceive
of potential plunges.
With the implied volatility
indexes at such fantastically low levels today, the traditional
warning signs of a major top are out there for all who are willing
to see. Fear will return to stocks, sooner or later, as
inevitably as night follows day. And only a sharp decline can
reignite fear in the thundering herd to restore balance to sentiment.
January 14, 2005
Adam Hamilton, CPA
email:
zelotes@zealllc.com
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