There is lots going on in the markets these days, volatility is increasing, geopolitical risk is everywhere, and the markets are seeing a lot of froth. So much froth in fact that it's next to impossible to filter out the noise if we only look at the action in the equity markets. Traders often look to other markets to generate trading signals, and one of the main ones is the VIX , i.e. the "fear gauge".
Before we look any deeper, it should be noted that even the usual way of gauging "fear" (not really fear per se, the VIX is simply an index of the premiums being paid for options. While speculation definitely goes on, most pros use options as insurance against drops, so the thinking goes, the more fear is in the market, the more investors are willing to pay for insurance, and thus, a higher VIX), i.e. simply looking at the VIX, suggests caution. As we can see from this chart, the VIX has followed a fairly predictable oscillation topping out at the $21 level and bottoming at the $12 level. However, the most recent leg down immediately following the January 7% mini correction saw the floor of the VIX rise to the $14 level. This is not in and of itself alarming, or indicative of a coming correction, just something to note.
But the purpose of this article is to pick apart the VIX a little deeper. This little trick was shown to me years ago by an excellent trader, he suggested looking at the VIX relative to the markets. By doing this, we can tease apart the data and reveal (to a certain extent) what the smart money is doing. And lately, the VIX seems to tell us the smart money is leaving the party. How so? Take a look at the VIX relative to the SPY.
The solid line is the SPY, the dotted one is the VIX. What this shows us is that for the last 3 years, we've had the SPY routinely outperforming the VIX. The SPY and VIX typically trade inversely to each other, but clearly the correlation is not 1. What this chart tells us is that even as the SPY climbed higher and higher, investors weren't really too worried about a correction. Options selling is typically done by highly sophisticated and plugged-in investors, and when they do not demand high premiums in a non-stop rising bull market, it generally bodes well for the market as a whole. As a simplified way of looking at it, as long as the VIX line remains above the SPY line, it signifies that the smart money is comfortable and confident in the bull market, and one should stay long.
We can see this trend stopped in early 2014, when the VIX line crossed down over the SPY despite the SPY continuing to go higher. The SPY is no longer outperforming the VIX and hasn't for two months. It appears the smart money is quietly exiting out the backdoor of the party even though the music has been turned up and the dancing girls just arrived.
Same chart, just shorter timeframe.
We can see this trend has played out in the Dow (NYSEARCA:DIA),
and the NSDQ (NASDAQ:QQQ).
There aresome other technical charts that are telling us to be wary at this time. When we look at how the defensive stocks are doing relative to the overall market, we also see some warning signs. The below chart of SPY/XLU shows that for the past 12 months, SPY has overperformed the utilities. However, earlier in the year - at around the same time as the VIX started signaling smart money was exiting the party - we can see the same breakdown of the prior trend. This is relevant as another indicator of smart money. Many equity hedge fund managers have mandates to have a certain percentage of the fund in equities at all times. They cannot just exit the markets if/when they see a top. So what you'll see instead of a flat out exit of these funds is a reallocation within the stock market, from the more risky sectors to the traditional safety sectors, utilities being the traditional one.
To be sure, if any of these charts happened alone, we would not be too worried. However, when all these red flags are flashing at once, we feel it suggests a top, especially as it appears the smart money seems to be leaving the party.
But of course technical analysis can only suggest a top is forming. It can't tell us why it is, and for this to work as a true sell bearish signal, we want to look at some fundamental analysis to confirm. Most traders agree that the very best trades occur when technicals back up what the fundamentals are suggesting.
There are the two obvious elephants in the room here: The Fed and Crimea. I don't think I need to go into detail regarding these two, there's nothing new we can add to this conversation except to say it's our opinion that the market is being far too complacent with regards to Crimea. Putin is a KGB thug. A very shrewd thug no doubt, who has shown impressive gamesmanship during this crisis, but a thug nonetheless. We feel the market is treating him instead as a modern statesman, and taking him at his word far too easily. And the Fed is the Fed. Yellen will continue The Taper, and it is what it is.
We'll leave these two alone as there is not much we can add to this discussion.
We think the far more important story right now is China. Yes, the crisis in Crimea could become a black swan event, but in reality, there are many things that could become a black swan, and we feel it's foolhardy to allocate any serious capital trying to predict a black swan. China, however, looks like it could just be a good old fashioned emerging market horror story. Because China is the second largest economy in the world, and the biggest driver of global growth, it's easy to lose sight of the fact that China is still an emerging market, and as such, is not immune from the growing pains of any emerging market.
It's kind of like your newborn child playing with a priceless Faberge egg. Regardless of their intentions, they are simply too immature to be comfortably trusted with that kind of responsibility, even though this may be through no fault of their own. Ideally, China's capital markets would not be trusted with such global responsibility until they are more mature, however that is not the case and so we must deal with the realities of this situation. The realities are, if the Chinese economy slows down, so will the global economy. So much of the historically high earnings projections of US companies are based on expected growth in the huge Chinese market, if cracks in the facade appear, equities everywhere will suffer. And we believe that cracks are indeed appearing.
Among the negative data: Industrial output, retail sales and fixed asset investment all disappointed (IP - 8.6% YoY growth vs. 9.5% est., retail - 11.8% YoY vs. 13.5% est., FA investment - 17.9% YoY vs. 19.4% est.). This represents multi-year lows for growth in all of these, including 11 year lows for fixed asset investments.
Most worrisome was the stunning export growth reduction, with a 6.8% growth estimate coming in at an alarming 18.1% reduction.
As data pours in on China, economists are starting to notice and are downgrading GDP estimates. While some of these numbers may seem like not such a big deal (after all, America would kill for some of those disappointing growth numbers), we must remember that everything is relative. Expectations were so high, and US corporate growth was conditional on those expectations coming to pass. While 6% growth would be miraculous for the US markets, if Chinese growth for 2014 were "merely" 6%, it would be disastrous for the markets. And of course, as with all Chinese data, the accuracy can be somewhat suspect. We're not saying the data is fudged; however if it is, it is most certainly fudged to look better then the reality.
In summary, we feel that the technical analysis is confirming the fundamental analysis, which always leads to our highest confidence trades. On the fundamental side, we have:
- the Fed continuing the taper,
- China looking like its economy is cooling down
- Copper crashing
And on the technical side we see from the charts it appears the smart money is exiting the US equity markets (or at least rebalancing their portfolios in expectation of a correction). We're not necessarily calling a top here; trying to time the market is a mugs game, however we would be very worried staying long given the current situation. Because of our reluctance to time a top, we feel that rather then shorting the market, the best risk/reward trade is being long volatility (buying 3-6 month dated VIX calls). We feel the vol downside is capped to the $14-ish floor the VIX currently at, regardless of if the market continues to melt up higher. However, given the current sentiment and increasing risk off behavior, combined with what appears to be the smart money betting on a top, if we get even a modest correction, volatility trades will perform very well. And if we get a serious 10%+ correction in the stock market, huge profits can be made.
Disclosure: I am long VIXY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.