The stock market’s recent sell-off and sudden snap-back rallies – including a 2,000-point drop – served to vindicate my strategy of pushing into cash and avoiding the incessant volatility of a portfolio heavily weighted in equities…
None of the volatility came as a shock, though.
I knew very well this would be one of the most volatile years on record, given the asininity of energy wars, currency crises, geopolitical shocks, upcoming elections, potential government shutdowns, record highs on the markets, and the end of easing.
I also knew we were long overdue for the correction we recently saw, given two factors in May 2015.
One was a low reading on the CBOE S&P 500 Volatility Index (VIX). When this index is low, there’s an indication of high confidence.
The second reading was the surge in bets the VIX would rise quickly in the very near future.
At the time, the VIX sat at five year lows of 12. But given a surge in bets on higher VIX reads, I knew sentiment was quickly changing.
So many calls had been bought on the VIX that the ratio of calls to puts was 10-to-1.
That’s an extreme, scary even.
It was a huge bet that stocks will drop and the VIX will soar.
These two indicators combined, a multi-year low point in the VIX and a huge lopsided market in VIX options, have only occurred at the same time twice before.
The first was in December 2009. The VIX fell to 19 and the number of VIX calls outweighed puts 5-to-1. The S&P would fall from 1,150 to 1,050 shortly after.
The second time it happened was in June 2011. The ratio of calls to puts on the VIX surged to more than 5-to-1 yet again. The VIX had also dropped to at a relatively low level of 16. Within three months, the S&P 500 dropped almost 20% from 1,350 highs to a low of 1,100.
After catching the skewed data in late May 2015, we watched the S&P 500 dive from 2,120 to less than 1,880.
It’s why we’ve long recommended having a great deal of cash on hand before.
Now, in the run-up to the meeting of the U.S. Federal Reserve meeting on September 17, stocks have become even more violently indecisive.
And rightfully so…
After nearly seven years of close-to-zero interest rates after the Fed stepped in to stop the bleeding, there’s great fear the benchmark rate will be raised to a more “normal” level, damaging investments, the overall economy, making money even more expensive to borrow.
It’s why I’m still recommending cash.
Investors are scared to death…
One of our favorite measurements of investor fear is the Fear & Greed Index featured on CNN.
It’s made up of a number of sentiment indicators we’ve watched for years. The S&P 500 Volatility Index is in there. The “spread” between interest rates on junk bonds and investment grades bonds is in there. There are a few market breadth indicators to that show how widespread a market move is too.
The Fear & Greed Index combines all these indicators neatly into a range between zero (extreme pessimism) and 100 (extreme greed).
In early 2015, the Index sat at a high of 80 – indicating extreme greed. No fear. Just greed. Pure greed. It now sits at 13 – indicating excessive, extreme fear in the market.
If we were to follow the Baron Rothschild or Warren Buffett contrarian views on fear, we’d buy here… and wait.
Unfortunately, stocks are still overvalued, creating an obscene risk of a substantial bear market.
If this market has taught us anything, it’s to wait for extremes. That’s the best position to be in right now. We’ll be back with more shortly.