Seeking Alpha

Investors Need Caffeine To Wake Them From Complacency

|
Includes: DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWM, RYARX, RYRSX, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, UWM, VFINX, VOO, VTWO, VV
by: Jim Mosquera
Summary

Are complacent markets dangerous for investors?

Three measures of market complacency.

What do these three measures tell us?

The equity markets appear comfortable these days, at least in a statistical sense. The swoon into late December of 2018 appears a distant memory. In this article I examine measures of investor complacency and what they may signal for the stock market.

Investors Intelligence Advisor Survey

The first statistical indicator examined is the Investors Intelligence Advisor Survey. This organization surveys over 100 independent newsletter authors/advisors and determines their current market stance. This survey has been in existence since 1963. Rather than riding the bullish wave, Investors Intelligence assumes a contrarian posture - strong bullish sentiment is most evident near market tops. Conversely, strong bearish sentiment is typical near market bottoms.

It's important to qualify what's meant by "strong" sentiment. Investors Intelligence established a "normal" reading of 45% bulls, 35% bears, and 20% neutral. While this demonstrates a plurality of bulls, it's considered a typical reading. Investors Intelligence focuses their attention on extreme readings and their duration. They believe that when too many advisors think the same thing, they are wrong. This is consistent with comments made in Escaping Oz: Navigating the crisis on investor psychology. Once everyone is on board with a trend, there are no new entrants to convert and drive the trend in that direction.

For the last three weeks of June 2019, the advisor survey noted near or above 50% bulls and 18% bears with a ratio of approximately 3-to-1 bulls to bears. While the bullish readings don't match the frothiness of early 2018, they are elevated according to the survey scale. Bearish readings are in the low range of the post 2008 era. Of particular interest are the number of instances where the bull/bear ratio exceeded 3.0. Considering data going back to 1987, the majority of this bullish ratio occurred from 2014 to the present day. Conversely, bull/bear ratios of 1.0 or less were most prominent in the years from 1987 to 1998 with a defined cluster of bearishness in the 2008 year.

The market entered a very persistent phase of bullishness and shed most of its bearishness since the end of the 2008 financial crisis. This contrast is not evident at any other time in the history of the survey. Thus, we can conclude that advisors, as a whole, while not at recent peak bullishness, are as generally bullish as they've been.

St. Louis Fed Financial Stress Index

The Federal Reserve Bank of St. Louis maintains a very interesting financial stress index eponymously named the St. Louis Fed Financial Stress Index (STLFSI). This index, begun in 1993, comprises 18 separate measures heavily focused on interest rates and interest rate spreads. The STLFSI also contains two specific stock measures, the VIX and the S&P 500 Financials index. The STLFSI suggests that changes in the levels of stress in the economy will make the various components move in sympathy. The index oscillates around the value of zero (0) representing normal financial market conditions. Values below zero imply low stress while those above zero imply high stress. The STLFSI is a contrary indicator. Low stress reveals complacent investors - the market is nearer to a top than a bottom.

The first graph illustrates the entirety of the data series going back to 1994. Notice how values remain above zero (0) from the beginning of the series and how little changed they were through the stock market top of 2000 and the ensuing recession.

St. Louis Fed Financial Stress Index The second illustration zooms in on the period forward from 2008. You'll note the persistently low readings.

The STLFSI shows no signs of worry and consequently, a relaxed investment community.

St. Louis Fed Financial Stress Index

VIX

The next and last measure of investor complacency is the VIX or Volatility Index. This index is thought of as a fear gauge and it specifically measures the variance of at-the-money options on the S&P 500 index. The lower the value of the index, the greater the degree of investor complacency. The numerical value derived for the index suggests the expected move in the next 30 days.

As I write this in early July 2019, the VIX is approximately 13. A VIX of this level suggests investors anticipate a move of (13/√12 = 3.75) 3.75% either up or down. The lowest VIX of the last 25 years occurred in early 2018 with a value of 9, (2.5% up or down). The VIX is an oscillating figure, thus it needs to be evaluated within a broad period.

The chart below illustrates this oscillating nature. The reader should note the slight change in trend towards higher values since the early 2018 low mentioned earlier.

VIX Low VIX readings tend to precede stock highs and high readings can precede stock lows. This is not to suggest that just because the VIX is at a particular level, it implies a stock high or low. Use the VIX reading in conjunction with stock market levels and other measures to understand how complacent a market may be. Utilizing this approach, we are at historic complacency after a strong ten-year bullish run in the equity markets.

Summary

I could also include the Daily Sentiment Index (DSI), another contrarian indicator that while lower than it had been in April (91% bullish), remains in elevated territory. Another contrarian sentiment indicator is the Rydex Total Bull/Bear ratio that measures the proportion of bullish to bearish assets held in Rydex mutual funds. The three most recent high readings occurred in January 2018 - coincident with the low VIX noted earlier - September of 2018 and in May 2019. The first two dates preceded significant market declines.

The phrase, "calm before the storm" comes to mind. Markets are remarkably complacent and that usually precedes a move of some significance. Periods like the one ahead will test investor risk tolerance. Investors think they're tolerant while they're making money. Once they start to lose, they'll discover they weren't so risk tolerant after all and complacency evaporates. The market supplies its own caffeine jolt.

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.