With the US
stock markets surging nearly a third higher in just 6 months, the odds are
rising for a major topping. As the best times to sell high, recognizing these
events in real-time is very important for traders. But it is a big challenge
due to the gradual way toppings unfold. An indicator that can really help is
the famous implied-volatility fear gauges. They tend to exhibit unique and
identifiable behaviors at toppings.
This is
counterintuitive at first, as the dangerous emotion of fear is rightfully
associated with bottomings. Traders get scared when
the markets sell off sharply, and fear flares as new interim lows are hit.
Toppings, on the other hand, are exciting times laden with complacency,
greed, and sometimes euphoria. These equally dangerous emotions are at the
far opposite end of the markets' sentiment spectrum from fear.
And this is
the key, greed and fear are mutually exclusive.
I've always thought of popular market psychology swinging back and forth
between these two extremes like a great pendulum. If markets have just
plunged to new lows, the resulting overpowering fear vanquishes all other
emotions. And if markets have just climbed to new highs, fear is nowhere to
be found. Greed can only exist in the absence of fear.
Thus the same
implied-volatility fear gauges that so precisely flag major bottomings can also be used to discern toppings. High
readings in them denote extreme fear, only seen at bottomings.
And low readings reveal the lack of fear, which only happens when that
sentiment pendulum swings back to extreme greed. So while there is no greed
equivalent of "fear indexes", they effectively reveal the whole
fear-greed continuum.
Of course the
most popular fear index is the VIX, which uses complex formulas to crunch
S&P 500 (SPX) options prices expiring over the next 30 calendar days.
Basically the higher options prices go, the more near-term volatility traders
expect. And volatility spikes dramatically during episodes of fear, while
collapsing when greed reigns. So a high VIX effectively indicates fear, and a
low VIX the absence of it.
Shouldn't
volatility be equally likely in greedy toppings? Maybe in theory, but
definitely not in practice. Greed and fear are very asymmetric in their immediacy.
Greed is a slow motivator, few traders are in a
hurry to buy high after a strong rally. But fear shocks traders into immediate
action, prices spiraling down to new lows spark an intense psychological need
to sell instantly. So high volatility is truly a fear thing.
While the VIX
is fine, I prefer the original old-school VIX now known as the VXO. This only
looked at S&P 100 options, the top 20% of SPX companies. And it only
looked at at-the-money options. During sharp selloffs, the biggest and
most-liquid stocks are the first and most heavily sold. Only they have the
necessary liquidity to absorb big selling. And at-the-money options are
quicker to respond with bigger moves than out-of-the-money ones. So the
classic VIX, today's VXO, remains a superior fear gauge.
As this first
chart shows, the VXO indeed behaves in a certain unique way when major
toppings are unfolding. The VXO S&P 100 implied-volatility index is shown
in red with the SPX superimposed in blue. The time horizon encompasses our
current cyclical stock bull that was born in March 2009. Each time a major upleg tops before a major correction, the VXO's technical
behavior is quite similar.
This strong
bull market has witnessed two previous major toppings, after each of its
first two major uplegs. They occurred in April 2010
and April 2011, which is another seasonal
reason why many traders are looking for this bull's third major upleg to top in spring 2012. By comparing the recent VXO
and SPX action with that seen in those earlier indisputable toppings, we can
better forecast the next major one.
First note
that the earlier toppings were gradual, the SPX slowly climbing to new
highs before plunging sharply in steep corrections. This again highlights the
inherent asymmetry in greed and fear, with the former building slowly while
the latter erupts quickly. Therefore the VXO behavior marking these toppings
is a lot less sharp and defined than the isolated massive fear spikes seen at
major bottomings.
And just like
the VXO has an effective
ceiling of 50 during times of extreme fear (excluding ultra-rare panics
and crashes), it has a floor during times of extreme complacency and greed.
And that is in the lower teens. The VXO rarely goes below 11 or 12, even
after a multi-year cyclical bull has driven serious fear spikes far from
traders' memory. So that is effectively the fear floor, or therefore the
greed ceiling.
While the VXO
rockets up to bounce off its ceiling during bottomings
after sharp corrections, its floor approaches in toppings are vastly more
gradual. The VXO's rate of decline gradually slows, creating the fear decay
curves shown above associated with toppings. For lack of a better term, I
call this asymptotic flattening. In math an asymptotic curve keeps
approaching a line (the asymptote), but never quite hits it.
As fear
decays and therefore greed grows, the VXO continues to bleed off at an ever-slowing
rate as it approaches its effective floor. So the very existence of these
asymptotic curves ushering the VXO into the low teens is a major topping
flag. While they don't offer wonderfully precise sell signals at toppings
like the sharp spikes' buy signals at bottomings,
this pattern is still fairly easy to identify in real-time.
Second, these
fear decay curves are usually interrupted by a sharp VXO spike higher in the
couple months right before the ultimate SPX topping.
These spikes correspond to pullbacks, relatively minor retreats in the stock
markets that are far from correction magnitude (over 10%). Within the gradual
stock-market topping process, there is almost always one sharp pullback just
before the final ascent.
Pullbacks are
essential in toppings. They rebalance sentiment, ensuring that greed doesn't
climax prematurely before all potential near-term buyers have been sucked in.
Pullbacks also help convince skeptics that they should indeed buy so late in
a major upleg. When the initial sharp selling in a
pullback doesn't snowball into a full-blown correction, plenty of traders
still hiding on the sidelines are persuaded to buy.
After these late-upleg pullback-driven
VXO spikes, this fear gauge quickly collapses back down into its original
decay curve. The lower the VXO gets in an absolute sense, the longer it has
been near those levels, and the more horizontal it trends, the higher the
odds a major topping is happening or imminent. Such low volatility levels
imply greed and complacency has reached unsustainable extremes.
So unlike the
short-lived highs the VXO sees at major bottomings,
its famous fear spikes, major toppings are marked by long-lived lows.
This is critical to understand, as the implied-volatility fear gauges are often
misused by traders when trying to identify toppings. I often hear analysts
say because the VIX hit 15, or 14, or whatever, that a major selloff is
imminent. But that isn't necessarily true, the decay curves are gradual.
Back to the
chart above, note how long it took for the VXO to asymptotically flatten
towards its effective floor as this bull's first two major uplegs started topping. We are talking about several
months or more, a very gradual process, after various new VXO lows
for an upleg are witnessed. Compare this precedent
to the VXO's decay curve today, and it is readily apparent our latest VXO
flattening still looks premature.
While the VXO
has fallen into the low teens relatively rapidly so far this year, it sure
hasn't spent much time down there yet. So the horizontal component of
the VXO decay curve really hasn't been seen. Does this mean the SPX can't
have already topped or won't this week? Of course not, but it certainly
lowers the odds. Today's VXO decay curve is still due to extend horizontal
for another month or two.
We did get a
notable pullback spike in the recent early-April stock retreat, which will
probably prove to be the necessary one before the topping. Even though it was
much smaller than in the first two uplegs'
toppings, this is to be expected. The older a cyclical bull gets, the more
general background fear fades away. So the VXO lows, and lesser spikes, tend
to gradually decrease as a bull market matures.
Based on its
bull-to-date precedent, the recent SPX and VXO action make it look like the
gradual topping process for this bull's third great upleg
has indeed started. But given how short-lived the late-March VXO lows were,
and how the flattening of the VXO decay curve hasn't gone horizontal yet, we
probably haven't seen the ultimate top. Nevertheless, traders should be very
cautious here.
This next
chart certainly isn't one of our prettiest, sorry. I wanted to examine the
VXO decay curves leading into SPX toppings in more detail, so the VXO axis
has been exploded to a narrow bottoming range between 12 and 21. And for each
major topping, I looked at the periods of time between when the VXO first
crosses major milestones in that particular upleg
to the SPX's ultimate peak in that upleg.
I'm
interested in how long the SPX topping tends to occur after a
particular VXO low is first reached in that upleg,
and the percentage of trading days between that initial VXO low and the
topping that are under that VXO milestone. So in this bull's first major upleg, the VXO first went under 20 4.9 months before the
SPX ultimately peaked in April 2010. And after that first sub-20 VXO close,
66% of the trading days between it and the upleg
top had VXO closes under 20.
For each upleg this data is noted, starting with the VXO first
closing under 20 and ending with it first closing under 14. This admittedly kludgy methodology gives us a hard empirical baseline
from which to measure the visual VXO decay curves leading into toppings. And
it helps us compare this latest VXO flattening with the ones signaling the
ends of this bull's earlier major uplegs, ideal
sell-high times.
The first
important takeaway is to realize that the VXO falling below a certain round
level on close for the first time is definitely not a topping signal as
traders like to argue. Regardless of which VXO milestone is being discussed,
the actual SPX tops occur weeks to months after a VXO low is first
seen. So unlike major SPX bottomings with huge fear
spikes hitting important absolute levels, toppings are much fuzzier.
Since the
topping in our current third major upleg is still
unknown, I took the metrics out to today rather than assuming the recent
early-April high was the topping. So as of this week it's been 3.7
months since the VXO first closed under 20, and 98% of the trading days since
then have seen sub-20 VXO closes. Contrasting these metrics with previous uplegs' is interesting, buttressing the
topping-coming-but-not-here-yet thesis.
The first upleg didn't top until 4.9 months after the VXO first
closed under 20, and the second until a whopping 7.3m later. So by this
measure today's 3.7m span to present is definitely on the light side. The
same applies to the first sub-19 VXO close and sub-18 VXO close as you can
see above. This fear gauge hasn't yet spent enough time under these milestone
levels recently based on bull-to-date precedent.
The comparison
gets murkier at the VXO sub-17, sub-16, and sub-15 levels. Our current upleg has seen the VXO spend considerably more time under
these milestones than it did in this bull's first upleg,
but considerably less than the second. So is there a particular upleg behavior it is more logical to err towards? The
first one's topping was sharper and faster, while the second one's was
prolonged and more gradual.
Due to the
way sentiment unfolds in an ongoing bull, our current upleg's
topping is more likely to be of the gradual persuasion. Early in a new
bull just after a brutal cyclical bear, fear remains quite high as traders
are frightened the bear will return. So there is much skepticism on whether
or not a new bull is even unfolding (as opposed to a bear-market-rally trap).
Thus selling tends to cascade more quickly at any sign of weakness.
But as the
months and years of cyclical-bull rallying mount up, naturally the background
level of fear steadily fades. So on average as bulls mature, fears of a big
selloff (even a correction) wane dramatically. And with fewer traders
motivated to sell rapidly, toppings become even more drawn out. Thus
probabilities favor major topping processes lengthening as a bull
market slowly matures.
And with our
current cyclical bull being born way back in March 2009, we are now nearly 38
months into it! The average lifespan
of previous mid-secular-bear cyclical bulls in modern history is just under
35 months each. So our current cyclical bull is definitely getting long in
the tooth, drawing out toppings and pushing the VXO to lower floor levels
than we'd have any chance of seeing early in a bull.
By these
later gradual-topping standards, we haven't yet seen enough time between
various milestone VXO lows first being hit and
today. And this comparison looks even more lopsided if the month between the
latest SPX interim high and now is subtracted out. Thus in VXO-decay-curve
terms, it sure looks like the SPX hasn't topped yet but is probably on course
to sometime in the next couple months or so.
Naturally we
are closely watching this unfolding topping process at Zeal. It is very
important. While the best case is this coming topping merely precedes another
mid-bull correction, there is a good chance it may actually mark the end
of this cyclical bull. And if that proves true, we are in for another
brutal cyclical bear that will probably batter the SPX back down near its secular support
at 750 over a couple of years!
While
cyclical bears can indeed be very profitably traded on both the short side
and long (sharp bear-market rallies), the necessary trading strategy is
radically different from what works in cyclical bulls. If you haven't traded
through a cyclical bear before, or even worse don't know one is upon you
until too late, you are probably going to get slaughtered. Thankfully we can
help you navigate whatever is coming.
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The bottom
line is the implied-volatility fear indexes can also be used to identify
major toppings. While they don't measure greed and complacency, the absence
of fear is necessary for these topping emotions. Following big stock-market uplegs, fear gradually decays until the fear indexes
start flattening towards horizontal. After some months of fear slowly
evaporating, the stock markets finally carve a major top.
While the
latest fear-index reads suggest the topping process has already started
today, we are still a month or two out from the ultimate stock-market highs
based on bull-to-date precedent. This is actually very fortuitous, as it
gives speculators plenty of time to layer out of positions put on for this upleg. And cash is king after any topping, whether it
leads to a mid-bull correction or a new bear market.
Adam Hamilton,
CPA
May 05, 2012
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