Lower Prices, More Optimism
Thursday, June 24th, 2004 8:20pm EST
Low-risk?
Bottom Line: Respondents to the lowrisk.com sentiment survey did not become very bearish at the May lows, and now they are nearly as bullish as they have been in four years, despite the broader market holding below recent highs.
In the last comment, I showed how, when bullish sentiment is excessive, the broader market has tended to under-performed those times when it is at the opposite extreme. That is, of course, nothing new, but I think it’s important to remember that we are currently seeing one of those times when bullish sentiment is too high. The Investor’s Intelligence survey, discussed last time, is only one of the several surveys we follow, and tonight I wanted to show something that troubles me about one of the others.
The poll posted at lowrisk.com asks participants whether the Dow Jones Industrial Average will be higher or lower by 2% thirty days from now. I’ve talked before about how, like the AAII survey, there are serious flaws in the methodology of their data collection, but still both surveys have proven themselves useful guides in the past and so far that does not seem to be changing.
The chart below shows a 4-week moving average of the bull ratio (bulls / (bulls + bears)) for the survey over the past year, with two divergences labeled “A” and “B”.
Point A1 is where we were as of last Friday, at which time the Dow Jones had not broken out above its April highs. Yet, at point A2, we can see that bullish opinion in this survey is well above where it was in April. These types of bullish expectations are also evident by point B1, where the Dow had broken below its March lows, yet the bullish opinion in the lowrisk survey barely dipped, and held well above the lows it saw in March.
I suppose one could make the argument that since these survey respondents were so bullish in May, and they happened to be correct in that assessment, then their current excitement may be a good thing. However, the history of these traders is the same as it is for all the other sentiment surveys we follow – when there is a unanimity of opinion, the market tends to go the other direction with a high degree of consistency. And as of this week, that is not encouraging.
Volatility Hits the Skids
Bottom Line: Implied volatility has been scraping along at new yearly lows, but that is not necessarily a bad thing.
One of the bears’ arguments about this rally is the decimation of implied volatility in the broad-market options gauges, as seen by the low readings in the VIX and VXN. Almost a year ago, I presented a chart that showed the seasonal pattern of the VIX throughout the year (click here to see the comment with attached chart). The chart clearly shows that the two months that typically see the lowest volatility readings are June and July. It has then picked up a bit in August, jumps again in September, then peaks in October. That’s the historical pattern, anyway.
So although the recent low volatility readings should not be a surprise, they continue to get a large amount of press, almost exclusively with the bearish overtone that low volatility is a prelude to a market decline. While I think that statement is generally effective when the market is in the midst of a sustained downtrend, when it is in an uptrend the story changes. To see if we can put some facts behind these assumptions, the charts below show how the S&P 500 has performed the given number of days after the VXO (the “old” calculation of the VIX) hit the lowest level it had seen in the past year. The charts include three lines:
1. Avg – All (thick black line): this shows the average performance of the S&P 500, regardless of the level of the VIX.
2. No Confirmation (red line): this shows how the S&P performed after the VIX hit a new yearly low, and at the same time the S&P DID NOT hit a new yearly high.
3. Confirmation (green line): this shows how the S&P did after the VIX hit a new yearly low, at the same time the S&P hit a new yearly high.
We can see from the chart that in the short-term, meaning the first 20 days, when the VXO hit a new yearly low the S&P was positive fewer times than average. 30 days later, the best performing instances where those times when the VXO hit a new low at the same time the S&P hit a new high, and that was again the case from 90 days to a year later. Now let’s look at the average returns:
Here, we see that the S&P underperformed an average period of time across all time frames after the VXO hit a new yearly low – it did not matter if the S&P hit a new high at the same time or not. Interestingly, the worst performers after 60 days were those times the VXO hit a new low at the same time the S&P hit a new high. The S&P actually showed a negative average return after such occurrences (due to instances in July 1987 and July 1998).
The fact that the widely-followed implied volatility measures have recently hit new yearly lows is not as bearish an indication as many make it out to be. While the S&P has had a tendency to show a smaller average return after the VXO became so low, it was typically not a dramatic difference. Also, the “divergence” between volatility and price (meaning volatility has hit new lows while the underlying indexes have not hit new highs) is generally not very bearish either, and in fact in some respects the market has done better when there was no confirmation than when there was. A push lower in the VXO was an excellent sell signal from 2000 through early 2003, but in our current market environment, it takes on a different meaning and I would not be shorting the market based on that measure alone.
Conclusion
Today’s action in the broader market was nothing extraordinary after the breakout from the day before. Our shortest-term, intraday measures hit a confluence of overbought readings by this morning, and for the most part that was worn off by the afternoon decline, leaving most of them back in neutral territory. However, with a clear mini-breakout that is getting so many traders excited after a couple of weeks of boredom, and the high likelihood that we saw an important intermediate-term low in May, it seems unlikely that we will immediately turn tail and reverse lower, in spite of some of the negatives outlined recently.
Longer-term, I’m just going to keep repeating what I have been saying for weeks now…May saw an important intermediate-term low, declines that put us into an oversold situation should be viewed as opportunities to add or initiate long exposure, we should see modest gains for the year, but the best strategy will most likely take advantage of oscillating indicators (selling overbought conditions and buying oversold ones) rather than breakout strategies. The closer we are to the top of the trading range, the less inclined I am to be holding long positions.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosure: no positions
This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.
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