MorningWord 9/26/14: Sentimental Value – $SPX

by Dan September 26, 2014 9:30 am • Commentary

This is not a market call, just an observation, but I suspect in years to come we will remember this past week as a sort of sentiment top for the greatest leg of a relentless bull market that was forged from what seemed like an unending commitment by central banks to prop up risk assets.  I am not calling a market top, but a sentiment top.

Last Wednesday, the Federal Reserve brought their historic bond buying palooza down to a mere $5 billion a month.  Apple, whose stock had gained more than $150 billion in market cap since the 2014 lows, finally released the highly anticipated new bigger, bendable phones.  Finally, the largest IPO the world has ever seen (from China of all places) priced on our shores.   Oh, and this morning Bill Gross, founder of the largest bond fund in the Universe, left the company he founded to join Janus.  Janus happens to be a mutual fund complex that was the poster-child for the internet bubble and by some accounts almost went under when it burst in the early 2000’s.  Weird happenings to say the least, all at a time when complacency seemed to be at its height (the S&P 500 made a new all time high just this past Friday).

From an economic standpoint, the case for continuing to own equities could remain very much intact.  If we see geopolitical issues settle a bit, commodity prices remain subdued, bond yields take a “considerable time” to rise, global growth (specifically China) prospects improve at a time when the ECB and Japan grab the stimulus baton from our Fed, then equities likely have not topped.  But sentiment is a cruel mistress, and it is hard to ignore so many gigantic headlines at time when implied vol measure by the VIX had been pricing in such a small potential for a correction.

Enis has pointed out on numerous occasions that the low level of the VIX actually does not jive with the high level of monthly and yearly volatility that the market has seen during the current bull market.  For example, the size of the advance from the 2009 low to today is much more similar to the late 1990’s bull market than the 2003-2007 bull market, as Enis noted in an early July MorningWord post:

In other words, the rapid nature of the rally of this bull market rivals the 5 year move from 1996 to 2000.  From Jan 1, 1996 to the peak in March 2000, the S&P 500 index rallied from 616 to 1553.  From the low of 666 in March 2009 to the May 2013 local high of 1687, the S&P 500 index actually had a larger rally (and it has continued over the past year as well).

However, the late 90’s rally was characterized by a VIX that was usually above 20, while the current rally has been characterized by a VIX that has usually been below 20. So the long-term volatility has been the same, but the daily volatility has been dramatically different.  That simple fact is to me a sign that any future correction is likely to be quite sharp and severe, and see another VIX snap higher similar to the only major corrections of this bull market – the 2010 flash crash and the 2011 summer swoon.

Both of those VIX snaps higher occurred at the end of a QE program.  However, it has been 3 years since the VIX has moved substantially higher, so traders have become accustomed to any brief selloff quickly getting bought.  For example. VXX, the short-term VIX instrument, is actually flat since June, but short interest has continued to rise, up 50% in the past 3 months:

VXX short interest, courtesy of Bloomberg
VXX short interest, courtesy of Bloomberg

That’s simply one more sign of complacency that is a result of several years of no real correction. While the current selloff might not necessarily lead to a 10%+ correction, the risk/reward is certainly skewed against bulls at this juncture given the numerous signposts that suggest a cautious stance.

I alluded to this sort of “sentiment top” on this past Tuesday’s Fast Money program on CNBC: