Mission Unaccomplished: Still Too Much Confidence For a Sustained Rally

All in all it wasn't a bad week...the indices lost a little ground, but are still up for the last ten trading days. The NASDAQ Composite lost 1.1%, while the S&P 500 gave up 0.5%. But, over the last two weeks, the NASDAQ is still ahead by 4.0%, while the S&P 500 is up by 2.2%. So, the past five days could mostly be chalked up as the calm after the storm rather than a break of the bull trend, right? Well, not so fast...

Yes, things were likely to cool after giant gains from a couple of weeks ago. But have they cooled enough? According to sentiment measures, no, they haven't cooled enough...not even close. 

How Much Cooling is 'Enough' ? The VIX Will Let You Know. 

In an edition from a couple of weeks ago, we first highlighted how the CBOE S&P 500 Volatility Index (VIX) showed a high degree of investor confidence and complacency - a condition typically met with an unexpected correction. As we had observed over the course of the year (and for many years now, truthfully), each rally - even the small ones - was started when sentiment was extremely bearish. Since the VIX had been persistently low over the last couple of weeks, we knew most of that confidence had to be bled off by way of a market dip. If any rally was to get traction, it would need to be started when confidence was shaky and investors were nervous...and while the VIX was much higher than usual. The strategy is called contrarianism, and works just like it sounds - take the opposite position of the trend when investors get overly-bullish of overly-bearish. 

Well, while there are always multiple reasons for why the market does anything, we have to say the weakness this past week was rooted in the fact that the wrong conditions were in place to keep the bullish move going...a condition signaled by a very low VIX reading. 

Why? Think about it like this...for the market to actually head higher for any length of time, buyers have to pace their cash flow back into stocks. But, to re-invest in the market, they actually have to be out of it. There's the rub. Despite a rough 2nd quarter, the market isn't down for 3rd quarter...it's just gone sideways to slightly higher for the last several weeks. Investors don't have any money 'sidelined' they're willing to put into stocks. Instead, it's all pretty much been invested. That's why the VIX has been so unusually low since July (and even June, except for one brief spike)...because investors really are confident and complacent right now, and they've said so with their dollars. 

The problem is, the market can't get going without any additional money coming into it - any cash that was going to be put in is already in. Oh, you might get a flash of bullishness here or there, but to really jump start a bullish move, there has to be a massive buy-back...something this market is not geared for right now. Before it happens, we'll need to see a fear-founded mass exodus from stocks, or a real indication of new money being flooded into stocks. The fear-based selloff will be indicated, as you may have guessed, by a super-high VIX. Once we see it happen, then we can reasonably expect to see stocks turn bullish again. 

Take a look at the nearby chart of the S&P 500 (SPX) and the CBOE Volatility Index (VIX). The picture tells the story (although with a lot less than the standard 1000 words).

The NASDAQ's Completely Skewed Volatility Index

Want to see something even scarier? The CBOE NASDAQ Volatility Index (VXN) hit multi-week lows last week, despite the NASDAQ's loss (the VXN should generally rise as its underlying index loses ground). True, the NASDAQ actually made a slight gain of 0.15% on Friday, but that sure doesn't justify the VXN's 13% dip on the same day. And for the week, the VXN still closed 7.9% lower, while the NASDAQ pulled back by 1.1%. What was everyone so confident about that caused investors to push the VXN lower, even as the market was giving ground? Good question. In our honest assessment, it was a mistake - one based on a combination of hope and the desire to buy on a dip. All we know is that VXN plunges all the way to the lower Bollinger band have signaled a heck of a lot more bearish market turns than bullish ones. 

As far as the VXN's unusual move on Friday goes, it's probably one you've already thought of...institutional money. If the major pensions and hedge fund managers were pouring tons of cash into bullish call options, and driving their prices higher (one of the factors used to determine the VXN level), it could have skewed the VXN into looking highly bullish. Our take is this...sometimes that 'smart' money isn't nearly as smart as you might think. Those big guys can fall into the same trap the little guys can collectively fall into. So, don't assume you'd be making the right choice if you were trying to follow their lead. In fact, the VXN's dip may have just been the entry into a hedge position against an even bigger bearish position. Point being, don't get too bullish because the VXN broke to new lows...the last time it happened, it ended up being a set up for a major market correction.

Bottom Line

Look, anything can and will happen - you know that. And we know we mentioned this exact same idea a couple of weeks ago. However, it's still one of our key worries even if it's not a concern to anybody else. Between the calendar, the lack of volume, and the bizarre degree of confidence indicated by the VXN and VIX, we just see more downside in store in the short run. So, once again, it may be a good idea to start exploring bearish trade vehicles. The good news is, the deeper this dip is, the bigger the Q4 rally should be...and yes, we think the fourth quarter is going to be at least as bullish as usual. 
 

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