 Amazing SPX Complacency
"Please be careful"
Adam Hamilton
Archives
September 24, 2004
One of the most striking attributes
of the US stock markets these days is the utterly amazing levels
of popular complacency.
Today's investors and speculators
generally seem totally oblivious to the concept of risk, content
to revel in the widespread belief that the US markets can only
power higher from here. This attitude that nothing bad can happen
to the markets as our economy "recovers" is ubiquitous.
It is probably impossible to
read a newspaper or watch financial television today without
being struck by how virtually everyone is convinced that higher
stock prices are inevitable. The extraordinary levels
of complacency are not just evident in the hard-to-measure financial
newsflow and popular psyche though, they are throwing up red
flags in all the classic empirical sentiment indicators.
One of the most famous of these
indicators is the VIX S&P500 implied volatility index. Probably
the most widely watched sentiment indicator on the planet among
hardcore index speculators, the VIX acts like a fear gauge. When
markets are due to bottom and bounce higher because popular fear
has grown too great, the VIX can soar to breathtaking heights.
And when the markets are topping due to unsustainable popular
greed and complacency, the VIX slumps and fades.
The VIX really measures the
implied volatility of a basket of S&P500 options. A group
of calls and puts are weighted based on their time to expiration
and the distance from their strike prices to the underlying S&P500
(SPX). This complex formula forms a composite hypothetical at-the-money
SPX option that expires in 30 calendar days. The implied volatility
number computed from this hypothetical contract mirrors popular
sentiment and moves inversely with the markets, hence
it makes a fantastic contrarian indicator for speculators.
Just last week, the VIX closed
at 13.17, an almost unthinkably low level not witnessed since
January 1996! And this week the S&P100 implied volatility
index, now known
as the VXO, closed at 12.86! Options volatility, and hence popular
fear, is just falling off the face of the earth. With the US
elections rapidly approaching, traders have grown convinced that
nothing can drive these stock markets lower.
Yet when everyone dominates
one side of a trade, the long side in the case of the US markets
today, contrarians grow very wary. If market
history teaches us only one thing, it is that markets abhor
extremes of any kind. If the vast majority of players grow too
fearful, the markets will defy them and surge higher. And if
the vast majority grows too greedy and complacent, the markets
start brazenly spiraling lower to trap the longs. The majority
is always wrong at major turning points.
I have been watching the fascinating
interaction between the SPX and the VIX all summer with increasing
interest. As our graphs this week reveal, generally the VIX has
been trending lower as popular complacency surges ahead of the
US presidential elections. Yet, paradoxically, the general markets
as represented by the mighty S&P500 are also trending lower
too! Typically fear, and hence the VIX, ramps up as markets fade,
but the incessant election noise this year seems to be breeding
a fascinating anomaly.
As you can see in this first
chart, prior to 2004 the VIX tended to rise when the stock markets
were weak. Since early this year however, both the VIX and the
SPX have ground lower in unison. Strange things are afoot in
the stock markets friends!
Back in the early years of
the Great Bear in 2001 and 2002, we used VIX extremes, especially
the spikes, to actively
trade the massive shockwaves ripping through the stock markets.
Speculators were watching the VIX with enough awe and affection
to rival even the QQQs
at times. These wildly oscillating markets after the tech bubble
burst were exceedingly fun and profitable to trade. While extreme
volatility causes investors to wail and gnash their teeth, speculators
live for hyper-volatile markets like these.
All of the major tradable interim
bottoms of 2001 and 2002 were marked by massive VIX spikes. And,
as shown above by the vertical red arrows, VIX lows coincided
rather well with SPX interim tops before very serious stock-market
slides. In fact, the three major VIX lows marking extreme complacency
in 2001 and 2002 formed a lower support trendline that is drawn
above in red.
Provocatively, this same lower
support line for the VIX formed in the early years of the Great
Bear, when extended to the present, has evolved into today's
downtrending VIX support. So far in 2004, this old VIX support
line has been hit a half-dozen times or so. We will discuss this
further below, but I wanted to point it out to you on this long-term
graph for context. The VIX once again bouncing at Great Bear
support is certainly a noteworthy event.
First though, looking at this
long-term graph is almost like seeing two unmatching body parts
stitched together to form some kind of Frankenstein's Monster.
Prior to March 2003, big market moves, and corresponding wild
volatility swings, were par for the course. Since March 2003,
volatility has just kind of faded into oblivion and the S&P500's
moves have been vastly smaller.
This massive discontinuity
in volatility profiles in the US markets corresponds exactly
with Washington's invasion of Iraq. Just prior to the unleashing
of the dogs of war, the US markets appeared to be headed for
a steep waterfall
decline for multiple serious reasons. Yet, once the bombs
starts landing in Baghdad as the world watched on CNN, the whole
face of the stock markets suddenly, some would say miraculously,
changed.
I point this out because some
traders believe heavy US government (or Fed) intervention in
the stock markets helped fuel the war rally. Others, including
me, tend to lean the other way and believe that the war
rally was sentiment driven fueled by an explosion of popular
relief that the war uncertainty had almost ended. Regardless,
whether the war rally was artificially manipulated higher or
a natural consequence of jubilant sentiment, the volatility profile
of the markets dramatically and suddenly changed.
After the war rally erupted,
sentiment grew more and more complacent as the markets continued
rallying in 2003. The VIX, betraying this stunning reduction
in volatility and hence fear, retreated all of last year. Finally
early this year it ground low enough to hit its old Great Bear
support line. And then things started getting really interesting!
Notice above how the spectacular
war rally in stocks ended just as the VIX slammed into
its old support line. Right after this year dawned, the VIX was
finally battered down to support and the SPX topped at the same
time. I don't think this VIX support intercept was necessarily
the cause of the SPX top, but I do find it intriguing
that an old Great Bear support line that hadn't been visited
for almost two years marked the very point where the VIX refused
to go any lower. Complacency had grown as popular as it could
possibly be so a correction was in order to restore sentiment
balance.
And since this SPX correction
started, the US markets have been in a shallow, yet unmistakable,
downtrend. This new downtrend is bound by the blue lines above.
It is really curious to see the markets grind lower for the better
part of a year now while the VIX also decays lower at the
same time. Yes, the VIX is showing signs of life on the high
end and is not as unnaturally compressed as it was in the second
half of 2003, but it too is in a surreal downtrend with lower
highs and lower lows as 2004 marches on.
So, in a macro sense, there
is an increasingly anomalous disconnect between the stock markets
and sentiment. After three failed attempts in a row this year
to achieve new SPX highs, the bulls ought to be sweating here.
The fear they forgot about last year should be welling up in
their bellies again, like an old and unwelcome stalker. Yet,
if the VIX is to be believed, there is no
fear. For whatever reason, an SPX fading into a downtrend
is not causing any angst.
I suspect the most likely cause
for this strange development is the upcoming election. Traders
seem to be divided into two camps on it. Not pro-Bush versus
pro-Kerry, but on the election's probable effects on the markets.
The first group thinks the Fed will do anything in its power
to keep the markets smooth and rising into November. The second
group scoffs at the bumbling government's inept attempts to manipulate
any market effectively, but they still fear the mob psychology
of the first group.
The first group expecting a
concerted manipulation campaign tends to want to be long, or
at least to not want to sell ahead of their expected election
rally. Now whether the government can really move the markets
higher or not over any meaningful period of time isn't really
important. If enough people believe it is possible, and
trade accordingly, then the mere fear of government intervention
creates a self-fulfilling prophecy. Traders don't sell because
they believe the government wants the markets higher, and the
markets end up staying high since traders aren't selling. Governments
know this and exploit it through "jawboning" the markets,
creating a perception of power to herd traders where little or
none really exists.
The second group is at the
mercy of the first group. All throughout market history governments
have proven all but impotent in manipulating markets. They relentlessly
throw fiat money at the markets, things go their way for a couple
hours or days, and then the primary trend crushes their feeble
interventions. Contrary to popular belief, free markets are exceedingly
difficult to steer, even for nation states.
Nevertheless, the second group
can't short the markets before the elections because the first
group is trading on their beliefs. If the majority of people
believe the markets should head higher into the elections, so
they don't sell, then the markets will indeed head higher or
at least not plunge. Popular perception becomes reality. Thus
the second group that thinks government is inept and useless
has little choice today but to remain on the sidelines until
the first group gets past the election. Only then will the menacing
psychological specter of intervention be decisively dispelled
so the markets can return to normal.
The more I study market history,
the more I believe the second group is right. Governments try
to manipulate markets all the time, but bureaucrats are no better
at short-circuiting free markets than they are at running the
Department of Motor Vehicles. The collective buying and selling
decisions of tens of millions of individual investors acting
in their own self interests, even though each trade is small,
will ultimately dwarf the power of any government in the markets,
including Washington.
Heck, even all the immense
power of Japan, one of the largest economies on Earth, could
not prematurely end its own secular
bear. And if the US Fed was really any good at this manipulation
game, then the US markets would never have crashed in 2000. The
S&P500 would be trading north of 2000 today and gold would
be under $200. Yet, for all Washington's sound and fury, the
US stock markets have been grinding lower in recent years while
gold marched relentlessly higher. Secular market trends will
not bend to the will of nation states any more than they will
bend for you or I.
In fact, when we zoom into
just the VIX and SPX activity this year in our final graph,
it looks like volatility continues to work just fine from a micro
perspective. Yes, a macro anomaly exists since the markets are
decaying yet complacency, not fear, is rising. Over the short-term
however, the markets are pretty much working as they ought to.
Perhaps the popular perception that the US government will somehow
levitate the markets into the election is fraying at the seams.
With this expanded scale the
precision of the S&P500's downtrend is really apparent. With
four intercepts at its top resistance and three at its lower
support, this is a really well-defined trend channel. Any way
you want to slice it, the US markets have been relentlessly decaying
in 2004. A series of continually lower interim highs and continually
lower interim lows is definitely not a bullish portent.
Now the VIX, even though it
is amazingly low by historical standards, has been behaving pretty
much as expected within its recent narrow band. With its vertical
scale blown up to reflect this surreal ultra-low-volatility environment
in which we sojourn today, the VIX has been working just fine
as a contrarian indicator so far this year. The VIX has marked
interim SPX highs and lows amazingly well, even at this reduced
volatility scale.
Starting at the bottom, since
the VIX is best known as a fear gauge, check out the VIX's position
each time the SPX managed to bounce higher for an interim rally.
Each time the SPX ground down to its own support line, it didn't
manage to bounce until the VIX shot higher. These comparatively
large VIX spikes are readily evident at the March, May, and August
interim bottoms in the US stock markets.
Now since each subsequent SPX
bounce was at a lower low, popular fear should have been
rising each time as more players grew concerned. This fear, if
it had existed, would have certainly been reflected in the VIX.
During normal market conditions we would expect to see the VIX
shoot higher with each lower interim low in the SPX. Yet, like
the markets, the VIX highs in March, May, and August curiously
reached lower levels each time.
Probably due to the strange
election paralysis described above, complacency is growing
with each lower low in the markets. Rather than becoming concerned
and then worried about the declining stock prices, popular fear
is evaporating. This truly is an odd episode in history and it
will probably have quite a reckoning sooner or later. Once the
markets start trading like they ought to again and volatility
and fear increase we could really see some serious moves as the
markets compensate for this strangely subdued action of 2004.
And on the SPX's high side
the VIX has more or less behaved as it should from a tactical
perspective too. Each vertical red arrow above corresponds with
the VIX intercepting its lower support line. This lower support
line is the same multi-year Great Bear support drawn above in
our long-term graph. The lower the VIX, even over the short term,
the greater the general complacency and lack of fear in the markets.
It is fascinating that every
interim top in the SPX in 2004 has been marked by an extremely
low VIX reading. Just as we saw in the recent wild Great Bear
years, markets have the highest probability of heading lower,
even over the short term, when complacency balloons the largest.
Each of 2004's five intercepts of the VIX with its old lower
support line before this month have heralded sharp imminent declines
in the S&P500.
And, as you can see, the incredible
eight-and-half-year VIX low we witnessed just last week corresponds
to the latest VIX intercept with its lower support line. This
means complacency in the recent weeks has been extraordinarily
high and the markets ought to head lower very soon. The SPX corroborates
this analysis since it looks to be falling now after unsuccessfully
challenging its upper resistance line earlier this month, for
the fourth time this year.
Thus, the popular perception
that the stock markets will be magically levitated higher into
the elections is in for a serious challenge in the coming five
weeks or so before we vote. Here's the scenario…
The VIX, the ultimate fear gauge,
just hit its lowest level in nearly a decade. Even though
US equities are still trading at very expensive levels historically
in earnings-multiple terms, no one seems to fear that stocks
will ever head lower again. All is thought to be well in equityland
and the VIX reflects these rosy expectations of strong markets
leading into the elections.
But, the VIX just hit its multi-year
Great Bear support line for the sixth time this year. Every single
time that this has happened in the past year, not to mention
the past several years, a significant stock-market decline has
followed right on its heels. In 2004 so far, these declines have
tended to run for anywhere from three to five weeks or so, dragging
the SPX all the way down from the top to the bottom of its short-term
downtrend channel.
And, perfectly on schedule,
the mighty S&P500 has just unsuccessfully challenged the
top resistance of its own downtrend channel and is already heading
lower. Thus the amazing complacency in the markets as evidenced
by the VIX is conspiring with the SPX being near the top of its
own channel to point to an extremely high probability of the
markets heading lower in the coming weeks. The S&P500 could
trade down to 1060ish or so if this downtrend channel holds.
In light of all these intriguing
technical developments, the popular belief that the markets are
going to rally into the election in early November might just
be unceremoniously shattered. And if this fragile psychological
construct vaporizes that is keeping the first group of traders
described above from selling, then the second group with zero
respect for government's feeble abilities to manipulate the markets
may just move in for the kill. Their strategy will probably be
to sell aggressively.
With the S&P500 trading
at 23x earnings today compared to historical Great Bear bottoming
levels under 10x earnings, not to mention only yielding 1.8%
in dividends now compared to historical bottoming levels over
6%, the stock markets are ripe for a serious fall. Perhaps
the coming sentiment-driven short-term decline in the SPX just
before November will be the catalyst that removes the
veil of election indecision from traders' eyes and unleashes
the long overdue valuation-based liquidation.
We will be carefully monitoring
this potentially explosive unfolding stock situation in our newsletters
for our subscribers
in the weeks ahead. If you have any exposure to the general equity
markets at all, you would do well to vigilantly watch the markets
in the coming weeks as well. Things could get really interesting
really fast, with little or no warning.
High levels of general complacency
tend to virtually always mark major interim tops in market history.
Today's utterly amazing levels of SPX complacency, the highest
by far in nearly a decade, will probably prove to be no exception
to this fire-tested rule.
Contrary to popular belief
leading into November, the US markets are extremely fragile today
and the VIX is calling for at least a short-term fall, and potentially
even the first Great Bear downleg since 2002. Please be careful
until we see how this ominous scenario plays out in the coming
weeks.
September 24, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
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