No Fear in Stocks
Adam Hamilton January 16, 2004 3309 Words
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.
If you are looking for an excellent long-term place to park core investment capital in a strong bull market, but are wary of the ominous existing general-equity extremes, you should take a serious look at the long-neglected precious-metals arena. Gold and gold stocks have done fantastically well in recent years and the best is almost certainly yet to come. Even better, a fantastic buying opportunity on a major correction appears to be rapidly approaching.
If you are interested in learning about the best of the elite blue-chip gold stocks, we profiled a half-dozen of these amazing companies from a fundamental perspective in the current January issue of our acclaimed Zeal Intelligence newsletter for our subscribers. In this monthly letter I am continuing our search for the best gold and silver plays as well as working hard to discern when the optimum moment to buy has arrived. Please consider honoring us with your subscription today!
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 January 16, 2004 Subscribe at www.zealllc.com/subscribe.htm