 No
Fear in Stocks
Adam Hamilton
Archives
January 16, 2004
Happy days are here again friends!
The stock markets are soaring,
the US economy is said to be booming, an election year is upon
us, and popular euphoria is back in vogue. This unbridled optimism
permeating the financial markets is contagious and seductive,
and the vast majority of investors seem to be joyously heeding
its irresistible siren's call.
Everywhere that one looks in
the mainstream media these days, a deluge of hyper-bullish information
gushes forth like a geyser. Not only seeking to rationalize and
justify the popular mania, these reports seek to stoke the speculative
flames and cheer for even greater accelerating gains in the future.
Good news is grand, bad new is good, and caution or restraint
are nowhere to be found.
Yet, when the glowing stock-market
landscape is surveyed today, there is one longstanding element
that is conspicuous and troubling in its absence. You can search
far and wide and scour the major stock indices from top to bottom,
but I suspect that you would be hard-pressed to uncover much
evidence of an ancient and respected companion to the markets.
Fear.
There is no fear in stocks
today!
Fear is a necessary and crucial
moderating influence on the markets. While fear generally gets
a bad rap as no one enjoys being frightened, fear helps keep
speculative excesses in check and moderates euphoria. A stock
market without fear is like a Dodge Viper without brakes. Sure,
the acceleration is breathtaking, but when it comes time to stop
it is far less painful to slow down moderately than to go from
200mph to 0mph in an instant!
When fear withers away to nothing,
as it has today, greed usurps its place in the popular investor
psyche. Almost all of the major multi-month swings in the stock
markets that speculators try so valiantly to stalk and capture
are driven by the perpetual war between greed and fear. Stock
prices rise right alongside with naked greed, but stock prices
plunge when cold fear spirals higher.
The free markets innately limit
greed and fear, rendering these competing popular emotions mutually
exclusive near their extremes and finite in both duration and
intensity. I like to think of the ancient greed-versus-fear war
as a giant pendulum swinging through time. On one extreme is
greed, on the other is fear, and these dueling emotions are proportionally
mixed throughout the rest of the pendulum's swing arc.
As this great popular emotional
pendulum swings in one direction, either greed or fear starts
dominating and squeezing out the competing sentiment. Yet, as
this pendulum nears the far end of its arc, it slows down and
farther growth in an extreme popular emotional state becomes
increasingly difficult and then ultimately impossible. Once the
markets are as greedy or as scared as they are going to get,
the great sentiment pendulum mean reverts and swings back in
the opposite direction.
The implications for speculators
of understanding the perpetually oscillating emotional nature
of the stock markets are profound. When stocks get to an extreme
state like they are today, where greed reigns and fear seems
to be extinct, speculators need to start looking for a pendulum
swing in the opposite direction back to fear. No emotional state
can dominate a market indefinitely, and sentiment extremes are
telltale warning signs of a coming emotional mean reversion.
And stock prices always follow closely on the heels of popular
emotion!
How can we speculators discern
when an emotional pendulum extreme exists? The best way is through
time, experience, and real-world trading. The longer that you
and I watch and trade the financial markets, the more that we
will internalize their rhythms and the better that we will become
at anticipating their next major short-term trends. Legendary
speculator Jesse Livermore discussed the unparalleled and priceless
value of real-world experience
in great depth a century ago.
While experience is the most
important attribute for discernment, other technical tools for
indirectly gauging general greed and fear do exist. It is impossible
to measure popular euphoria and despair directly, but technical
tools have been created that grant us an excellent indirect proxy
view of where the great greed-and-fear pendulum may happen to
be at any given moment in time.
Among the most popular, and
best, of these technical tools are the famous implied volatility
indices. Measuring the implied volatility of a hypothetical basket
of 30-calendar-day at-the-money index options, the implied volatility
indices effectively deftly translate speculator behavior into
the underlying emotional states that spawn such trades.
When folks are greedy they
grow complacent and volatility declines, leading to a plunge
in the implied volatility indices. After all, when nearly everyone
extrapolates an unbroken super-bull trend into eternity, there
is no hurry or pressure to trade. When folks are fearful, however,
they soon get scared and volatility surges as they rush to liquidate
their current positions to reduce their risk profile and capital
exposure as rapidly as possible.
The implied volatility indices
capture these normal human behavioral patterns beautifully, soaring
on widespread general fear and plummeting on widespread popular
greed. There are probably no finer technical emotional gauges
widely available today.
This week we are reviewing
the two most famous implied volatility indices, the S&P 500's
VIX
and the NASDAQ 100 s VXN.
Both indices have reached deep lows suggesting that the great
sentiment pendulum is near the end of its arc deep in naked greed
territory and is highly likely to mean revert and swing back
in the opposite direction sooner or later here. Speculators must
strive to stay aware of the raw degree of the current mania-greed
extreme.
In addition to the respective
major US stock indices, their key moving averages, and their
own volatility indices, our graphs also contain standard 50dma
+/- 2.5 standard-deviation
Bollinger
Bands, which offer us even more insights into the current
state of popular investor sentiment. The stunning lows on the
VIX and VXN in recent weeks offer much food for thought for index
speculators.
The contrary nature of implied
volatility and the stock indices is very apparent when graphed
together. Just as contrarian speculation theory declares, investors
and speculators as a herd tend to grow most greedy and euphoric
near interim highs and most frightened and worried near interim
lows.
Major interim highs are always
marked by lower VIX implied volatility levels as few feel pressured
to trade when everyone is euphoric and hyper-bullish. Major interim
lows are always marked by really high VIX extremes as investors
and speculators rush to sell as fast as they can to end their
pain and exposure, which relentlessly drives up both actual
and implied volatility.
The VIX is effectively as practical
a gauge as any of general stock-market sentiment, swinging between
greedy lows and fearful highs as the tides of circumstance constantly
shift and change. And if you examine the last couple weeks or
so of VIX data in the graph above, you will note that the great
emotional pendulum has swung as far back into the extreme greed
range as anytime in recent memory.
As a matter of fact, these
days the VIX is trading lower than at any other time since 1996,
as even the Great Bubble mania top in 2000 didn't see the VIX
fall anywhere close to today's incredibly low 15ish levels! Just
as there was very little general fear in 1996, there is none
today.
Now the bulls will point out
that the mid-1990s time frame contained the years that launched
the Great Bubble speculative mania of the late 1990s, and I have
even heard some analysts claim that we are in for another similar
monster bull or bubble in tech stocks again in the coming years!
I suspect that such brazen predictions make investors who suffered
through past supercycle bubbles and busts turn over in their
graves, as back-to-back bubbles in the same stocks and indices
just do not happen in history.
While the VIX was indeed this
low in the mid-1990s, there were far more reasons for it to be
there than today. With the notable exception of the 1987 unpleasantness,
the equity markets had been in a strong and healthy bull market
since the early 1980s. Valuations were fairly expensive around
21x earnings, but the secular bull had launched off dismal valuation
lows near 7x in the early 1980s and had not yet approached the
fabled bubble realm above 28x. The long-term trend remained up
and investors played the fabulous Great Bull accordingly.
Today we have similar very
low VIX levels, betraying an unbalanced lack of fear, but our
situation is far different. The stock markets are not coming
off of valuation lows as in early 1980s, but off of supercycle
bubble valuation peaks in 2000. Amazingly the S&P 500 is
trading around 28x earnings again today, back into official bubble
territory in historical
valuation terms! Fresh new bubble valuations only a few years
after a bubble burst are unprecedented and ominous.
The dominating secular trend
in force today, even accounting for the awesome cyclical bull
market of the past year or so in US equities, is still very bearish.
In both valuation terms and long-term technical-trend terms,
the environment today could hardly be more different than that
during the mid-1990s the last time the VIX plummeted to such
incredibly complacent lows.
While a low VIX can exist for
years during a Great Bull, during a Great Bear an extremely low
VIX reading usually signals a major interim top. This is very
apparent in the graph above, as every greedy euphoric moment
where speculators ought to have been shorting the heck out of
the US markets is marked by low VIX readings. When in secular
bear-market mode, high greed and a lack of popular fear are key
warning signals to close out speculative longs and look for a
decent entry point for speculative short positions.
The yellow Bollinger Bands
confirm the VIX's assertion that greed is far too high and the
stock markets have grown very overbought. Today the S&P 500
is aggressively challenging its upper band, 2.5 standard deviations
above its key 50-day moving average. These standard-deviation
bands tend to mark extremes that are very difficult for a price
to break decisively out of, as is quite evident on the downside
in 2001 and 2002.
The S&P 500 has certainly
had a magnificent war rally since last March, or a medium-term
cyclical
bull since October 2002 if you prefer, but warning signs
abound today that current levels of popular greed are just plain
silly and unsustainable. Approaching official bubble levels at
28x earnings again, fundamentally the S&P 500 is in terrible
shape. The historical average fair-value level is only one-half
of today's valuations at 14x earnings, so investors today are
willing to pay twice as much for stocks today as they have over
centuries past, not a wise decision. And interest
rates are a copout, no justification at all for crazy bubble
valuations.
Couple the extreme overvaluation
rampant today with the bottom falling out of the S&P 500's
VIX, and it is readily apparent that the markets have become
unbalanced to the mania side. The great sentiment pendulum of
popular emotion is so deep into greed territory today that fear
is hardly even remembered. But, as always in market history,
one emotional extreme is an excellent harbinger of a coming mean
reversion back in the opposite direction.
As the great pendulum swings
and greed gradually makes way for fear, the S&P 500 will
fall through several key technical support levels. Its first
big test will occur at its 50-day moving average, around 1077
or so today. If its 50dma doesn't hold, its next stop is its
lower Bollinger Band and then its crucial long-term 200dma, which
both happen to be around the same 1004ish level today.
While few outside of the black-sheep
contrarian circles still believe that the Great Bear of 2000
has not yet ended today, I guarantee that there will be serious
soul searching by the bulls if the mighty S&P 500's 200dma
does not hold as support. Once this flagship index breaks decisively
under its 200dma on a fear mean reversion, it really could head
all the way back down to retest its bear-to-date lows near 777
from October 2002.
Although the timing of such
a move remains uncertain, speculators need to seriously consider
its possibility since the general level of fear as captured by
the VIX is far too low considering current valuations and long-term
technical trends. Ultra-low VIX readings during high-valuation
periods are not times to celebrate, but dire warnings that market
emotions are precariously unbalanced and that the great pendulum
may be preparing to swing back in the opposite direction towards
popular fear.
Not surprisingly, the Great
Bubble speculative ground zero of the NASDAQ and its NASDAQ 100
VXN implied-volatility index are singing the exact same tune.
In fact, amazingly enough, the VXN has managed to plunge to all-time
record lows in recent weeks. NASDAQ investors and speculators
are not only not scared, but they seem to have totally forgotten
that markets even can move both up and down!
Somewhat surprisingly, the
no-fear situation in the NASDAQ is even more extreme than in
the general equity markets. This is odd since it is a fairly
well known historical fact that the primary mania sector that
led a supercycle Great Bubble, like technology in 2000, will
absolutely not be the leader in the next major real bull-market
move.
If the same sector is leading,
like technology today, it signals a mere bear-market rally or
short-term cyclical bull, not a true new long-term secular bull.
Yet speculative and even investment capital is deluging into
the same old NASDAQ market darlings in a flood as if it were
1999 all over again. People are sure slow to learn!
The NASDAQ 100 variant of the
implied volatility index, the VXN, has plunged to all-time record
lows. This is not as extraordinary as it may seem if one did
not realize that the VXN was only launched in early 2001, but
still it is a notable event. Tech-stock investors, for some reason
or another, have totally forgotten the hard lessons of 2000 and
are chasing major tech stocks higher regardless of fundamentals
or reason.
The grossly speculative nature
of the current rally or cyclical tech bull is readily apparent
no matter where one looks. From the enormous explosion in volume
in the hyper-speculative OTC penny stocks to the staggering and
rising nosebleed valuations of the NASDAQ mega-caps, signs of
a mini-mania are everywhere. It still blows my mind every time
I ponder this surreal current situation, as I remember the many
painful lessons
from the Great Bubble all too well.
The NASDAQ as a whole is trading
above 38x earnings now, a phenomenally high valuation by all
historical and logical standards. The top 10 NASDAQ companies,
the biggest and best in the index, all have individually extreme
valuations too. They include MSFT at 30.1x earnings, INTC at
48.4x, CSCO 48.1x, DELL 37.5x, AMGN 36.8x, ORCL 31.0x, QCOM 60.4x,
EBAY 108.1x, AMAT with losses, and YHOO trading at 142.3x earnings!
The simple average of these elite leaders' valuations is a staggering
60.3x earnings, and they collectively command a market-cap exceeding
$1.1t!
Incredibly today's NASDAQ speculators
and investors are willing to buy the leading NASDAQ companies
at prices so high that at current earnings levels it would take
these entities a whopping six decades, until 2064, to earn back
the price being paid this very day for their stocks! Surely this
lunacy must remind you of something, a nagging memory and feeling
of unease over having witnessed such things before.
To me it feels like early 2000
all over again. We have a hyper-low VXN betraying enormous popular
greed and an extinction of fear. No one is scared because everyone
fervently believes that the NASDAQ will soar to the heavens soon,
except for a few battle-hardened contrarians. Couple this with
valuation extremes not witnessed since the 2000 bubble days,
and before that not since the late 1920s if ever in US history,
and we have an incredibly hazardous NASDAQ scenario brewing.
When the great sentiment pendulum
swings back from greed towards fear in the NASDAQ, it could be
incredibly painful for all those who chose to believe again,
just as they vainly did in 2000, that valuation no longer matters
in our brave "New Era". While the NASDAQ is challenging
its upper Bollinger Band now, its key support remains at its
50dma, lower Bollinger Band, and all-crucial 200dma.
When the inevitable sentiment
mean-reversion swing arrives, the first key level for the bulls
to defend will be NASDAQ 1972 or so, its 50dma. If you look at
the graph above you will note that the NASDAQ has not yet fallen
decisively below its 50dma since the war rally launched in March,
so a 50dma breakdown alone would be very unsettling for tech
speculators.
If the 50dma fails to hold
as support, the next major inflection point arrives at the NASDAQ's
lower Bollinger Band, around 1824 today. After that, it's the
absolutely crucial 200dma at 1757 or so. If the NASDAQ's 200dma
falls, the bulls are in serious trouble and once again folks
will start to believe that the Great Bear never really left but
was just biding its time in the shadows, letting the greedy bulls
fatten up a bit while it coldly stalked them.
While greed and valuations
are both far too extreme in US stocks today, the timing of the
sentiment mean reversion is still uncertain. This particular
rally since March has been incredibly resilient and has steadfastly
defied many key
technical levels that ought to have broken its resolve and
bludgeoned it back down. The US indices certainly could mean
revert from greed to fear at anytime, but the exact timing will
remain uncertain until the event actually transpires.
Nevertheless though, it is
not prudent to bet on a mania for anyone but gunslinging short-term
speculators who are ready to run for the exits on a moment's
notice. Just as in 2000, long-term stock investors will get slaughtered
like sheep when sentiment turns. Buying at 60x earnings and hoping
to sell to a greater fool is only for the boldest and most nimble
of speculators, not for precious long-term retirement capital.
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The general US stock markets,
although exciting, are burdened with far too much greed and far
too little moderating fear these days. The great emotional pendulum
of popular sentiment will not remain on the greed side of its
arc forever though, as it always swings back once an emotion
grows too popular.
When today's ultra-low implied
volatility indices are coupled with extremely high bubble valuations
in the major US stock indices, supreme caution is the order of
the day. The contrarian play is not to run with the frothing
herd this late in the war rally, but to sit back and wait patiently
until the current greed extreme resolves itself.
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
January 16, 2004
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