Earlier this
week, the flagship S&P 500 stock index (SPX) officially entered
bear-market territory. As it
edged past a 20% loss since its all-time high of October 2007, all debate
about whether or not a bear really exists was instantly rendered
irrelevant. Beyond any doubt we
now sojourn in a full-on bear market!
The fearsome
reputations of stock bears are well-deserved. During the legendary bear running
between January 1973 and October 1974, the SPX lost a sickening 48.2% of its
value. In a much more recent
specimen, between March 2000 and October 2002 the SPX shed 49.1%. Cyclical bear markets often tend to cut stock prices in half by the time
they fully run their courses!
While these
raw numbers alone are frightening, realize this is across the entire broader
markets. The 500 biggest and best
companies in the US
comprise the S&P 500. They
are involved in 9 major sectors and a myriad of actual businesses. They are the investment-grade elites,
the blue chips. Even these
companies, all the giants whose names you know, can easily see their stock
prices halved during a bear.
So needless
to say, bears are exceedingly dangerous environments for investors. Fools ignore bears at their own great
peril, and even the prudent are filled with plenty of trepidation. For the most part, you can’t
merely weather a bear by buying the best-of-breed companies. They will get sucked into the selling
too. Other than sitting in cash,
the only viable strategy for surviving, even thriving, in bears is actively
trading these merciless beasts.
And it can be done. Back in 2002, the last cyclical-bear
year until 2008, the SPX fell 23.4%.
It was an exceedingly terrible year for the stock markets, a time of
much wailing and gnashing of teeth.
Yet the stock trades we realized that year from our Zeal Intelligence
newsletter trading recommendations averaged 40.5% absolute gains. And since we held these for less than
4 months each on average, we were growing our capital at a 129.1% annualized
rate. Bear be damned, it was a
great year!
The key to
successfully trading bear markets is understanding their primary driver,
sentiment. The mission of a bear
is to gradually hammer on investors until their perceptions of stocks
radically change. When a bear
begins, optimism and greed abound and traders are far too complacent. But by the time the bear ends, all
hope has been beaten away.
Pessimism and fear remain and traders are totally demoralized.
It is
actually this excessive optimism that initially foments a bear. Near major tops, stocks get bid up to
prices far beyond what their earnings can support. A bear is necessary to eradicate these
valuation excesses. Over the course of a bear, valuations
are slowly eroded lower until stock prices are cheap relative to their
earnings near the end of a bear.
So bears rebalance both sentiment and valuations.
And while
the broad sweep of a bear is one giant slide from general greed to general
fear, there are smaller sentiment sub-cycles within its duration. Traders get complacent after
bear-market rallies, and scared after bear-market downlegs. It is these mini-greed-fear cycles
within the longer greed-fear cycle of the entire bear that can be so
profitable to trade.
To trade a
bear, traders have to carefully monitor popular sentiment. And then when it gets to an extreme,
they must do the opposite of what
mainstream market thought considers right. When the thundering herd is scared,
traders want to go long and buy stocks.
When the herd is greedy or complacent, traders want to go short and
sell stocks. Contrarian trading
within bears is dazzlingly effective.
While
monitoring consensus sentiment is something of an art form that comes with
market experience, there are some great tools available to get quick
reads. My personal favorite, and
I believe the most effective, sentiment gauge is the VXO implied volatility
index. By carefully studying and
monitoring the VXO, traders can thrive in bear markets by fading the majority
at both greed and fear extremes.
While
implied volatility is mathematically intense, the basic concept is
straightforward. All day
everyday, traders are gaming an uncertain future via the stock-index options
markets. Hedgers offload risk to
speculators, all parties making bets to try and maximize their returns based
on what each individual trader suspects is coming. Collectively all these trades, the sum
of every single active trader’s own bias and outlook, feed into options
pricing models. The result is
implied, or expected, volatility.
When traders
get scared, they expect more volatility ahead so their options trades made in
preparation drive implied volatility through the roof. When traders get greedy or complacent,
they expect smooth sailing and their options trades reflect this. So implied volatility dries up. It is really elegant conceptually,
using existing trades to define overall
market expectations for near-future volatility.
How
near? 30 days. The VXO calculates implied volatility
for a synthetic, at-the-money option on the S&P 100 index expiring 30
calendar days out. If this sounds
complicated, don’t worry.
The thing to internalize is a high VXO represents extreme general fear
(the time to buy) and a low VXO represents extreme general complacency (the
time to sell). The VXO
effectively distills popular sentiment into one number.
Before I get
into the mechanics of this, I have to digress briefly. The VXO is the implied volatility
index for the S&P 100 (the top 100 companies, 20%, of the SPX) but the
VIX is the implied volatility index for the S&P 500. So since everyone including me uses
the SPX as the market benchmark of choice, why not just use the VIX? While it certainly can be used, I
suspect the VXO is superior for a variety of reasons.
Until
September 2003, the VIX used to apply to the S&P 100 (OEX). That month the CBOE changed it to
track the broader S&P 500.
And not only did the VIX’s mission change, but a new formula was
introduced for its calculation too.
It incorporates a broader range of option strike prices, with
weightings increasing closer to at-the-money. So today’s VIX is totally new
since late 2003, not comparable with the last bear’s.
To preserve
the true historical VIX, the CBOE renamed it the VXO. Thus the VXO was battle-proven in the
2000-to-2002 bear (where it was called the VIX) while today’s bear is
the first the new VIX has ever seen.
While the VIX and VXO parallel each other closely most of the time, I
like the VXO’s proven track record. It is too bad the CBOE couldn’t
have named the new S&P 500 VIX something else instead.
And in bear
markets, when fear surges, institutional traders rush to liquidate their biggest and most-liquid holdings to
raise cash fast. This is the
elite S&P 100 companies. As
of the end of June, this top fifth of the S&P 500 accounted for 64.5% of
its market capitalization. This
is a big majority, no doubt, but it still means over one-third of the new VIX
will be driven by stocks outside of the base S&P 100.
Thus I
suspect at particularly ugly fear extremes, the VXO will decouple
meaningfully from the VIX for a few days. The VXO will go higher faster,
offering better trading signals.
The top 20% of the SPX is just vastly more liquid in panic situations
than the entire index. Big
traders will dump OEX companies first as they have much higher volumes and
much larger market caps so fast selling will have less of a price impact on
any individual trader’s realized prices on exit.
If my theory
proves right in this bear, the old-school hyper-liquid VXO will more quickly
and accurately reflect tradable fear excesses than the somewhat-watered-down
VIX. Until I see how the VIX does
over an entire cyclical bear, I’ll continue to watch the VXO that has
proven so useful in history.
While I’ll write a whole essay on the VXO versus VIX debate
someday, that’s the nutshell version if you’re curious.
Digression
complete, we can get into the actual bear-market trading mechanics. This first chart overlays the SPX on
the VXO during the 2000-to-2002 bear.
While that bear technically bottomed in October 2002, it retested
those lows in March 2003. And
that’s when the mighty 2003-to-2007 bull began. Since most analysts today consider
March 2003 the end of the early-2000s bear, I ran this chart out to early
2003.
The obvious
inverse symmetry here is visually striking. During an in-progress bear, traders
watching the SPX always wonder whether the index happens to be high enough
for an interim top or low enough for an interim bottom at any given
time. Watching the VXO
simultaneously with the SPX helps resolve this conundrum. The VXO’s largely-fixed range
combined with its sentiment-mirroring nature shows when to buy and sell in
real-time.
Since bear
markets fall on balance, we’ll start on the short side. Note above that each time the red VXO
line headed into the low 20s the stock markets soon started falling
again. S&P 100 implied
volatility around 20 or lower signals either excessive greed or excessive
complacency. Neither can last
long in an ongoing bear. A low
VXO, defined as low 20s and lower, is one of the best bear-market shorting signals.
Shorting
encompasses a variety of trading strategies. If you happen to have long positions
or call options still on the books from the preceding bear-market rally, they
should be liquidated on a short signal to lock in your profits. New shorts or put options can also be
added ahead of the coming bear downleg.
No matter how you do it, on a low VXO extreme start positioning your
capital to profit from market downside.
As the
downleg foretold by the short signal matures, general fear really ramps up. Short positions grow very profitable
and fewer and fewer traders want to try and “catch falling
knives” and bet on a bounce.
With few buyers, stocks plunge.
Eventually fear gets so extreme that it becomes unbalanced and
excessive. This is also reflected
in the VXO, which is why it is most commonly called a “fear
gauge”.
Back in the
2000-to-2002 bear, VXO extremes marking unsustainable fear, and hence an
imminent sharp bear-market rally, gradually grew as the bear matured. Early on in late 2000, the SPX could
bounce off a VXO peak in the upper 30s.
By early 2001, this increased to 40ish levels. And in later 2001 and 2002, the fabled 50ish VXO levels of yore
were witnessed.
So whenever
the stock markets are falling fast and you are looking for a tradable
bear-market rally, watch the VXO.
It should peak somewhere between the upper 30s and 50 or so. That is when to close out all your
short-oriented positions and throw long via stock purchases and call
options. V-bounces within bears
are driven by extreme fear, which is only driven by sufficiently sharp stock
plunges.
This was the
problem in the markets this week.
As the SPX officially entered bear territory a few days ago, traders
were looking for a rally. By
itself, the SPX certainly did look
oversold. It had fallen 12.8% on
a closing basis in just 7 weeks! But fear wasn’t excessive yet,
the VXO was just nonchalantly meandering in the mid-20s. In the last bear, how many major bear
rallies launched from such low fear levels? Zero.
Over the
course of an entire bear, stocks gradually drift lower on balance. But from a tactical perspective, they
bounce back and forth between greed and fear. Traders cannot expect a major new
downleg unless greed and complacency are excessive. And they cannot expect a major new
bear-market rally unless fear gets excessive. Bears need to be traded near these
sentiment extremes, no other times are anywhere near as optimal.
So waiting
for real fear, as reflected in the VXO, before closing shorts and adding
longs is critical. And this begs
the vexing question. Should I
consider the upper 30s my long signal or should I hold out and wait until
50? Unfortunately there is no
clear-cut answer here, but I do have a couple thoughts that have really
helped my own trading.
First,
realize popular fear gradually grows over the course of a bear. Early on, few people believe a bear is
really upon them. Like the old
slowly-boiling-the-frog-to-keep-him-unaware proverb, bears stealthily unfold
so investors aren’t spooked too soon. And with lower background fear earlier
in bears, peak fear at extremes is also lower. Thus I’d be more inclined to
call the upper 30s my long signal while this bear still remains young.
Later, as
this bear matures, both background fear and spike fear levels will continue
to ramp. So mid-bear I’ll
be watching for the low 40s on the VXO and by the last third of this bear
(say spring to autumn 2009 or so) we’ll almost certainly see VXO 50
again. As general fear grows, the
VXO level at which a strong long signal can be declared will rise as well.
Second,
greed and fear run along a continuum.
Sometimes major trend reversals (from downleg to bear rally or vice
versa) can happen at lower emotional intensities than usual. So hard-and-fast VXO targets, on both
the upside and downside, are problematic. Instead, think in terms of a
probability scale. The higher the
VXO, the better your odds for success with longs. The lower, the better your odds with
shorts.
So actual
entry points can be scaled in and gamed a bit. If the VXO hits the upper 30s, close
some shorts and add some longs.
If it goes higher still after that (meaning the SPX fell farther), add
more long positions. But once it
gets to 50, even if only for a moment, it is time to throw long aggressively
and close out all shorts.
Historically the VXO rarely exceeds 50 and if it does it is for an
exceedingly-short period of time.
VXO 50 is as close to an absolute fear top as you can get.
Also realize
that fear extremes heralding a V-bounce and major bear rally can happen
anytime during the trading day.
If fear peaks at noon, and no one is left to sell, the VXO will also
peak at noon. Thus the intraday
VXO high can be significantly higher than the closing VXO level. While these charts in this essay show
VXO closes, at every extreme I noted two numbers. The lower one is the VXO close that
day while the upper one is the intraday VXO high. They are both worth pondering.
The
practical application for traders here is this. Once the VXO gets to 35 or so, start
watching the darned thing religiously, every minute of every day. Odds are the actual fear peak, and
hence tradable stock-market bottom, is not going to happen conveniently right
at the end of a trading day.
Another clue the bottom has arrived in real-time is stocks are in a
free-fall and the CNBC talking heads are very frightened. After you see a few bottoms unfold,
you’ll know just what to look for.
All these
lessons from the last bear can be applied to our current bear. While young, the VXO and SPX are
already behaving very similarly to the ways they did early on in the early-2000s bear. I rendered this chart of our current
bear at the same vertical scales as the previous one for comparability. Stocks are falling while both
background fear and spike fear are gradually ramping. Welcome
to the bear market!
Back in
early October when the SPX bull finally gave up its ghost, the VXO fell to
15. These are very low levels
showing extreme greed and complacency.
But back then of course the cyclical bull had not yet failed. Low implied volatility levels are
common late in bull markets as fear is long-forgotten. By late 2007 it had been five years since we’d seen a
sharp selloff and fear-driven VXO spike!
But as 2008
dawned, increasing signs of a new bear market emerged. In January 2008, I wrote about the
increasing odds for an impending cyclical bear
based on Long Valuation Waves. After the March lows, we were riding
the SPX bear rally higher in commodities stocks. But by early June, it was once again
apparent that a new bear downleg
was upon us. It has really
accelerated in the past month.
So far in
our young bear, we’ve only seen one full bear downleg (October 2007 to
March 2008) and one full bear rally (March 2008 to May 2008). Since then, we’ve entered this
bear’s second major downleg.
With this structural perspective of the ongoing SPX bear in mind, the
VXO’s behavior is very interesting and nicely echoes its famous
characteristics of the past.
At the peak
in October, greed was high and the VXO was very low. This was a great time to short with
such abnormally-low implied volatility, even in a bull. While stocks soon started sliding,
they really accelerated into January.
Fears grew pretty intense for a spell. The January VXO peak on a closing
basis was 33, not high. But
intraday it approached 39, which is much more typical of an early-bear
tradable bounce.
The SPX did
indeed bounce, but failed to enter a full-blown bear rally. By March it was plumbing new lows that
saw VXO tops of 34 closing and 37 intraday. Probably because fear wasn’t too
particularly extreme here, the subsequent bear rally wasn’t all that
impressive either. It only ran
12.0% higher from March to May, well under the 20.5% average for major bear
rallies in 2001 and 2002. Of
course that bear was more mature by those years than our cub today, which
might help explain this.
But when the
VXO again started falling under 20, and ultimately under 15 briefly in May,
it was clear the bear rally was running out of steam. A new downleg was being born. So even in the young bear since
October, using the VXO as a fear gauge to game major interim reversals has
been quite profitable. I’ve
talked about each reversal as it happened in our newsletters, and the VXO
level was always a major clue.
Watch the VXO closely, shorting at low levels and buying at high
levels.
So trading
bears is indeed possible, and quite profitable. And today it is easier than ever
thanks to the proliferation of new ETF-like trading vehicles. Now stock traders can short stock
indexes, and sectors, with leverage in some cases, directly out of normal
stock trading accounts by buying ETFs.
This is a vast improvement from the last bear when all we had was
outright shorting and put options.
In the new
July issue of our monthly Zeal Intelligence
newsletter, I discussed many of these new bear-trading vehicles. You’d be amazed at all the neat
new ways to game short-side exposure!
I also discussed some of the reasons why this bear is likely to
persist for at least another year or so, granting plenty of downlegs and bear
rallies to trade. Subscribe today,
join us in thriving through a difficult bear environment that crushes normal
investors.
The bottom
line is we are officially in a new SPX bear, and it remains quite young. While bears slaughter buy-and-holders,
they offer outstanding trading opportunities. Prudent and disciplined contrarian
traders who can buy when everyone else is scared and sell when they are not can
earn fortunes over the course of a bear.
The greed-fear-greed-fear downleg-rally-downleg-rally cycle is really
fun to trade.
And the
implied volatility indexes, particularly the classic VXO, are the best
one-stop proxies for general greed and fear levels. The higher the VXO (fear), the higher
the odds for success in new long trades.
The lower the VXO, the higher the odds for success in new short
trades. And this holds true
regardless of where the SPX happens to be trading on any particular day.
Adam Hamilton, CPA
Zealllc.com
July 11, 2008
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Fire away at zelotes@zealllc.com. Due to
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I will read all messages though and really appreciate your feedback!
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