Recession? Not Today

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Includes: BXUB, BXUC, DDM, DIA, DMRL, DOG, DXD, EPS, IVV, IWM, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USMC, UWM, VFINX, VOO, VTWO
by: Maksim Koliakov

Summary

Sentiment analysis indicates bulls are still strong.

Do not pay attention to VIX.

Get ready for a market correction, not a bear market.

All main American stock indices are steadily growing during the last 2 years. The traditional approach based on technical or fundamental analysis cannot satisfy the needs of today's market reality. Technically, the market has been overbought for a very long time (important notice: we have not seen any strong market correction for two years). Fundamentally, the market is overpriced, and it continues to hit the new record highs. Against this background, it does not matter whether you use technical or fundamental analysis because your research will show you the same picture as it was a year ago.

What is left? Sentiment analysis only.

In order to gain a comprehensive overview, let us focus on Fear and Greed Index (as a broad measure of an ongoing market sentiment), VIX and other interesting facts.

Fear and Greed

Fear and Greed Index (CNN) is a useful analytical tool, which tracks the dynamics of the seven indicators (stock price breadth, market momentum, junk bond demand, safe haven demand, stock price strength, market volatility, put and call options). Stock price breadth is based on McClellan Summation Index, market momentum is measured by 125-day moving average, junk bond demand is simply the spread between yields on IG bonds and junk bonds, and safe haven demand mirrors the difference between returns for stocks and returns for treasuries (20-day stock and bond return). Market volatility is measured by the VIX, stock price strength reflects the number of stocks hitting the 52-week highs and lows, and put and call options show the CBOE 5-day average put/call ratio.

The last step is to compute an equal-weighted average of these seven indicators (each indicator oscillates between 0 and 100). It is the final reading of the index. The higher the reading, the greedier the investors are and vice versa.

The Fear and Greed Index shows how market participants prefer to deal with their money now. Although it is quite volatile and tells you nothing about margin debt or short interest ratio, the Fear and Greed Index shows the current market condition quite well.

Source: money.cnn.com

A brief look at the chart of the index gives an understanding why the bullish sentiment is still strong: during the last weeks, we have seen the extreme readings only (now it is 65). However, let us dig dipper and look at the index components. While the market-related metrics are still extremely bullish, market volatility is neutral and put/call options ratio expresses the extreme fear.

Indeed, if we examine the CBOE put/call ratio data, it gains a strong positive momentum. The number of puts is growing during the last weeks. It is a good warning sign.

Secondly, attention should be paid to junk bond demand. The index is so high because everybody hunts for ‘fruitful’ returns. Unsurprisingly, the yield spread between junk bonds and investment grade is at the lowest levels in history (below 2%). According to Bloomberg, even the CCC-rated sovereign debt (Mongolian, for instance) moved below 6 percent yield.

This idea is also clearly reflected by the Barron’s Confidence Index. In plain English, this index represents the ratio between the best grade bonds and the intermediate grade bonds. When the ratio is high, investors are ready to take more risk, so the market is confident. The recent dynamics show that the current year is much more optimistic than the previous one.

All this situation with yield spreads could be another early warning sign. Usually, narrow spreads indicate that the main markets are fully loaded with capital, and the CCC-level yield dynamics confirms this idea.

Should we care about VIX?

If we examine the VIX chart for the post-crisis era, we will often see the readings below 15. The question is how to interpret such new readings.

First, VIX alone does not give the investors an edge in the next market move. VIX is not a predictor. VIX shows the market expectations based on options. Usually, we see the volatility spikes when the selloffs occur and vice versa.

I can understand this big attention to derivatives (especially, after the Global Financial Crisis). Indeed, the record low VIX readings make the investors feel a little bit anxious. Moreover, the lack of stock market correction adds more fuel to the fire. However, the recent shift towards the passive investing explains such a low VIX. It is a tough task to outperform a soaring stock market, and everybody in the industry understands it.

The market is going up, and the investors finally turned to the passive and “buy-the-dip” mentality – why should anyone be surprised by low VIX? It is not the cause but the result of the previous market activity.

Are there any other facts?

Only two (three – with VIX) out of seven indicators of the Fear and Greed Index show a warning sign. It means the bull market is still strong, but it could be enough for the market correction.

The data from the University of Michigan can be an excellent contrarian indicator. If we speak about the sentiment, the recent data tell us that the previous two years can be characterized as exceptionally bullish. The last figures showed very optimistic expectations about the future of the stock market (the current numbers are at the pre-crisis level).

Another fact worth mentioning is monetary policy. The world’s major central banks (the Fed and ECB) begin to unwind the stimulus measures. Common sense tells that if quantitative stimulus fuels the market growth, the QE reverse will have a negative impact. However, it is not that simple. History knows an interesting case of “taper tantrum”. Hence, it all comes down to a single question: is the Fed ready to go all the way to policy normalization despite possible incidents?

The bottom line

Bear markets are about recessions and global economic downturns. In fact, now we cannot undoubtedly say that something big and nasty is just around the corner. We may see a significant market correction soon (the analysis above shows that), but the market euphoria – which is badly needed for the last stage of the bull market – may not be the best word to describe the current market condition.

It is hard to say today’s market is euphoric because every analyst is telling you about the threat of an upcoming recession. Indeed, we see tons of articles and reports about geopolitics, uncertainties about the Fed, and extremely high market valuations.

That is why we need to see the “death” of the last “bear”. It will be a turning point for the markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.