As most of you know, sentiment is a strange bedfellow when it comes to financial markets. It’s usually dire or running hot at the opposing extreme in the actual market, bottoms or tops. I’ve always felt that investors pay too little attention to sentiment, while traders pay too much. Gauging pessimism or exuberance can be difficult, and risk assets have a tendency to overshoot. As we contemplate a record of consecutive, record high closes for the S&P 500 (SPX) I think it is important to keep a close eye on what is attracting new money into the market, especially from those that have been disillusioned with owning stocks since the financial crisis. Here’s some headlines from major financial publications:
Bloomberg: Don’t Let the Melt-Up Get You Down
There is a chance that this mentality could be the first stage of late 90’s like returns, but I suspect only if you subscribe to dollar cost averaging.
In the lead up to the Brexit vote I was dead wrong about a few things. First, since a early Spring, after the healthy bounce off of the January / February double bottom low, I was convinced that there was no way in hell the SPX would make a new all time high if it did not first have one more downward volatility spike testing the prior lows. My reason for that was the mounting headwinds to global growth. Secondly, I massively underestimated the chance of a Leave vote even though polls had it as a dead heat, and therefore the potential for that to be the impetus for a sharp sell off. And lastly, that Brexit sell-off being the thing that got enough money off-sides that a chase to get back in could take U.S. stocks to unrelenting new highs.
But that’s not big problem as long as you don’t compound it and get caught off-sides in the other direction. Just as sentiment went from bad in late June, to euphoric now, remember that recent signals from the BOE, BOJ and ECB (all in the last week) has been to hold off on “helicopter money” and more rate cuts. And with the recovery in markets, expectations are once again mounting for September FOMC rate increase (Fed Funds rate currently implying a 28% chance). That’s been the theme of the market the last few years. When markets panic, the assumption is we see a less hawkish FOMC and a more dovish ECB and BoJ. When markets get too euphoric we see the opposite. The central banks can kill moves that get too far one way or the other with well timed leak to the media.
So you probably see where I am going with this. Spot VIX closed below 12, very near the 52 week low made on August 5th 2015. That’s not exactly bullish, but does not spell immediate danger either:
VIX futures on the other hand still show a fairly sharp ramp, with Sept pricing about 17.25, Oct at 18.50 and Jan17 very 20. That’s a steep curve given where spot is.
So the lesson here is don’t press lows, and don’t chase highs. The VIX curve is showing you that. If you’re stung by the FOMO bug at the moment, and contemplating putting new cash to work at all time highs options can help. Only risk what you are willing to lose and define your risk over the next couple months. The SPX just rallied 9% since June 27th.
with the SPY at $217 you could buy the September 217/230 call spread for about 3.50, or about 1.5% of the etf’s underlying value. That gives you exposure for a continuation of the breakout and defines risk if we get another tape bomb like Brexit. If we have we have another one step up/two steps down scenario (especially when you consider the recent ramp in the SPX) you’re protected. And if complacency turns into irrational exuberance then that defined risk strategy catches the next 5% move in the market. For recent fence-sitters that’s probably the best way to manage the fear of missing out, while ensuring you don’t wake up one morning with the sort of mess that occurred last August and regret putting new money in at new highs.