Anxiously euphoric, two words that do not belong together and two human emotions that should not exist side by side. But here we are, suffering from both at the same time. The market rally of the past few months has been difficult if not impossible to trade if you care at all about market risk. Valuations are elevated, the Fed is about to let assets roll of its books, there is chaos on the Korean peninsula, Spain may fracture into two counties as the people of Catalan vote to secede from the country. The fracturing of Spain is a bad sign for the European project. If you don’t want to be governed by some people locally, you are not likely to want to be governed by some people far away, that speak a different language and follow a different culture. a hundred miles away.The only winners here have been those that were long equities before the rally started. Those that trade the
The only winners in the stock market have been those that are “buy & hold” investors. Those that buy and sell the short-term trends, rotate from sector to sector and pick stocks have lagged significantly. As a whole, the only winners in the active trading game were the momo investors who jumped on the Mega & Large Cap stocks held in the S&P 500.
One piece of evidence that supports this view is the performance of “human” run funds versus “machine” run funds.
Bloomberg LLP reports that the average equity fund was up 9.7% year to date, while the quant funds and pools donated by computer-driven algos rose only 0.6%. In some sense, this performance makes sense. The machines try to buy and sell the daily and weekly ups and downs of the market. Humans, on the other hand, tend to buy and hold for months or quarters and sometimes years. Those that buy index funds, tend to buy and hold for years. This is a perfectly good strategy when equity, bond, and real estate prices are rising, but is disastrous in a bear market. People who invested in index funds lost about half their wealth in 2000 to 2002 and again in late 2007 to early 2009.
Clever investors are looking for an appropriate time to sell their stocks as they seek to avoid the next big bear market. One way people do this is to search the internet for articles about particular topics related to their investments. With Google Trends we look at what people are searching for as they do their investment research. We see there are a few interesting themes people are searching/researching and leads us to conclude investors are simultaneously split between anxiety and euphoria.
The chart above shows that interest rates are as low as they have ever been. Market historians would argue that bonds are overpriced. Yields on long-term bonds are at or below the inflation rate. After tax, they are a guaranteed wealth destroyer. AS a result, many investment advisors argue that stocks and real estate are the only games in town as they have historically provide higher returns and some inflation protection. This has encouraged people to overweight equities. Many now argue that equities are just as overvalued as bonds. (Interestingly, however, if bonds are fairly priced, equities might be fairly priced too.) Given their concern, people are searching for information and data about equity valuation.
The above is an index of the frequency for people searching for the term “Over Valued.” It shows that people are researching this topic at historically hight trends. A reading of 100 means it has never been at the highest frequency. So this tells us that people are concerned about valuation.
At the same time, people have a split view on volatility. They know that volatility picks up when the price falls and that volatility can rise sharply in a sustained bear market. A review of the term structure of volatility suggests that people put a low probability on a selloff near term, but are more concerned about the long-term.
The chart above shows the VIX term structure. The VIX is just 10.13% at the moment, and it is important to remember that the VIX is simply the market’s estimate volatility for just the next 30 days. We as investors experience volatility in both the short and long-term. The steep term structure tells us that people are calm/confident in their short-term outlook, buy concerned in the long-term. If one looks out to May of next year, investors are discounting a volatility of 16.3% which is 61% higher than spot VIX today. We think this differential is what has kept the active trader, and high-frequency trading algorithms off-balance and under-invested.
This will not go on forever. Algos and momentum investors often chase market action. The chart above shows an estimate of the $Deltas ($Billions) of call options purchased going back to 2007. Investors have not been this aggressive in buying market risk through SPX index options since before the financial crisis. Buying calls is a way for investors to get exposure to the equity markets without taking on crash risk.
There are some other investors who are more bold and confident. These folks purchase Futures contracts on the S&P500 outright as they what full exposure and do not want to pay for crash protection with option decay. The chart above shows that there has been a great deal of buying of Futures Price at the “Offered” side of the market which suggests people are stepping up to buy.
The “catch up” activity in the options and futures markets suggests that we are getting closer to a tradable top. Price action is still inching higher suggesting that if you already long stay that way. We would suggest that if you are letting this winner run, keep a tight stop. Overconfidence is a trait of market tops, bot markets can rally for some time, while investor confidence continues to build.
If we observe a market signal that a tradable top is in, we will certainly discuss it here and offer suggestions for those who what to hedge their book or speculate on lower prices. One market signal we are keeping an eye on is the triangle pattern that is playing out, which is shown in the chart below.
One of the characteristics of this type of chart pattern is a sign of exhaustion. Both the up and down moves become more limited with time, so momentum slows down. The MACD at the bottom of the chart confirms this type of price action. At the same time, every shallow pullback is met with more buying, so the asset becomes increasingly over-bought with time. The RSI a the top of this chart confirms this type of price action. If and when we see a break of the lower trend line, the odds of a tradable selloff will be high enough to commit capital to this thesis. Until then, we wait.
