Amazing SPX Complacency

Adam Hamilton     September 24, 2004     3174 Words


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&P 500 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&P 500 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&P 500 (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&P 100 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&P 500 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&P 500’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&P 500 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&P 500’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&P 500.


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&P 500 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&P 500 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&P 500 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.


Adam Hamilton, CPA     September 24, 2004     Subscribe