The behavior of the US stock markets in recent months has been utterly fascinating. From the market-igniting presidential elections a couple months ago to the anomalous January weakness plaguing the markets now, strange things are definitely afoot.
To set the stage to investigate we first have to peer back into 2004. In the entire year until Election Day on November 2nd, the S&P 500 was up just under 1.7%. After topping early in the year, the markets were actually in a distinct downtrend until just before the elections when the bulls started stampeding.
But from Election Day until the end of the year, the S&P 500 exhibited stupendous performance and rallied another 7.2%. Fully 4/5ths of the gains for the entire year accrued in the last two months of trading after the election uncertainties finally evaporated! This strong and impressive election rally has led to today's environment where there is no fear in the stock markets.
In the first week of this year however, the S&P 500 actually fell 2.1%, a rather odd event. In a single week not only were nearly a third of the election rally's gains stripped away, but the stock-market performance in the first week of the year is considered to be a key metric for one variation of the popular January Effect. As goes the first week, so goes the year per this particular barometer.
So we had a 2004 that was trending relentlessly to a negative finish for its first ten months, then a powerful rally on an exogenous event that cannot be repeated for four years, and then a rare down first week in 2005 when fresh new pension capital usually deluges into the markets and boosts stock prices significantly. In light of these events I would think caution should be in order. A two-month election rally does not necessarily nullify a ten-month downtrend.
But, since stock investors as a herd have an attention span shorter than most five-year olds, the election rally has colored today's sentiment to a dazzling degree. The tyranny of the present is a constant threat to rational thought and adequate consideration of longer-term context. Per the popular volatility indexes that are the most widely respected sentiment gauges, there is literally no fear in the US stock markets today.
The famous S&P 500 VIX fell to a phenomenal decade low in late December. Its younger sibling the NASDAQ 100 VXN hit an all-time low the same week. For whatever reason, the majority of investors expect nothing but clean sailing ahead and aren't the least bit concerned that markets can move down even easier than they can move up. Complacency reigns supreme today, a very dangerous development.
As a contrarian speculator who monitors these things continuously, the extremely low fear levels today strike me with an unmistakable ring of déjà vu. In fact, a year ago this week I was writing my original "No Fear in Stocks" essay discussing the same unnaturally low fear levels per the volatility indexes. Only last year the VIX and VXN lows to date were 38% higher and 32% higher respectively, far less extreme than today's lows in retrospect.
This week I would like to update this volatility-index no-fear analysis, discussing the events of 2004 that led to today and what this may portend for 2005 in the major US equity markets. Anomalously extreme sentiment readings can only be ignored with great peril, and investors ought to take such rare developments very seriously.
In this chart the real technical nature of 2004 for the US stock markets is painfully apparent. Until just before the elections, the S&P 500, the best proxy for the markets in general, was grinding relentlessly lower in a crystal-clear downtrend. It bounced in a relatively narrow band between support and resistance, carving a series of lower highs and lower lows. It even fell below its key 200-day moving average, an early sign of stubbornly persistent technical weakness.
Thus, prior to the sharp election rally, 2004 was unfolding in an unmistakably bearish manner. You wouldn't know it from listening to the hyper-bullish general sentiment today though. When bullish mainstream investors talk about the markets these days, for the most part they can't seem to see much beyond the last couple months. The most recent short-term past, as always, has colored today's prevailing sentiment tremendously.
Meanwhile the VIX trended lower as well in 2004, also carving a narrow downtrend channel ultimately culminating in its decade low just above 11 in late December. This VIX behavior remains quite peculiar though. Usually the VIX moves opposite to the markets, as it did throughout 2001, 2002, and 2003. Yet it spent the first 10 months of 2004 trending lower right along with the stock markets.
The volatility indexes usually move contrary to the markets because they are sentiment gauges. A low VIX like today's means there is very low fear and very high greed or complacency, a herd psychological state only reached after a major rally. The higher the stock markets run, the lower fear gets. Investors tend to make linear assumptions with just the most recent data, they extrapolate the latest trend out into infinity and therefore wrongly become the most bullish right at major interim tops.
Conversely a high VIX means high fear and very low greed or complacency. Such fear-laden events only happen after major market drops, like the vicious series of V-bounces in the markets from 2000 to late 2002 rendered above. The lower the stock markets plummet, the higher fear mushrooms. And once again, since so few people have trained themselves to think as contrarians, fear is always greatest at a major bottom, exactly the wrong time.
So it is pretty odd for the markets to grind lower while fear falls with them, exactly the anomalous course of action for the first ten months of 2004. Even with a nearly year-long downtrend and a 200-day moving average support failure, last year investors just weren't the least bit worried. I suspect the elections had a lot to do with it. Investors assumed the markets were weak because of election uncertainty, and they were willing to accept this thesis at face value without further exploration or worry.
Now we are faced with an interesting situation where the markets are a bit higher this January than last January thanks to the election rally. But the already low implied volatility readings of last year have plunged off a cliff. Following last year's low volatility extremes, the markets grinded lower just as they should have. Is there any reason to think today's even more anomalous volatility lows will somehow shock and lead to a bullish outcome? I really doubt it.
Whenever I write about extreme VIX lows, I understandably receive a blizzard of e-mails pointing out that volatility was extremely low in the mid-1990s too, just before the spectacularly bullish last stage of the Great Bull that launched back in 1982. If the S&P 500 was able to rally off extreme VIX lows then why can't it do it again today? My answer is it certainly could, because anything can happen in the markets at any time, but I believe the probabilities argue strongly against it. The primary reason is the Long Valuation Waves.
Stock markets tend to move in great cycles running a third of a century or so each. These are driven by valuations. Stocks start cheap (1982), gradually become more expensive (1982-1999), hit a spectacular blow-off top (2000), and then their valuations decay until they reach undervalued lows again (2000-20XX) and the cycle begins anew like a phoenix. I have written extensively about these Long Valuation Waves and their immensely powerful mean reversions if you are unfamiliar with these important strategic cycles.
The mid-1990s VIX lows happened during the first half of a Long Valuation Wave when valuations were generally rising. Pretty much everything is bullish in the ascent phase of a valuation wave, as investors are in the process of bidding up valuations to high levels. Today though, since March 2000, we are now in the descent phase of this valuation wave. Today valuations are gradually sinking, either via stock prices falling to match earnings or earnings gradually rising to meet stock prices.
Expecting an extreme VIX low to be bullish in the latter half of our Long Valuation Wave, the descent phase, is not a very prudent bet. Valuation seasons must be considered in long-term sentiment interpretations, as a weather analogy illustrates.
In both March and September in the northern US, gorgeous sunny 60-degree days are witnessed. Even though the days may be identical, the March day portends higher summer temperatures coming while the September day warns of lower winter temperatures approaching. Would it be wise to see a 60-degree day in September, remember the similar glorious March day, and assume that because the September day was like the March day that summer would be coming again in November and December while winter was totally skipped? Of course not!
The current valuation season matters tremendously for anticipating stock trends just as real seasons matter for predicting temperatures. The mid-1990s VIX lows occurred as valuation summer was approaching, the peak point of the current Long Valuation Wave. Today's VIX lows are occurring as valuation winter is approaching, the low point of the valuation cycle. Thus I think it is not prudent to interpret today's VIX lows in the same light as those of a decade ago.
Speaking of valuations, last January Wall Street's main argument in favor of ignoring the extremely low prevailing fear levels at the time was that US corporate earnings would rocket higher in 2004 to justify the historically high valuations. They argued that, while stock prices were certainly expensive in early 2004, they wouldn't seem high by 2005 once earnings exploded. Were they right?
As 2004 dawned, the S&P 500 was trading at 27.7x earnings. This is incredibly high in light of history, where the average valuation over more than a century has been 14x. In fact, once above 28x a market is officially a bubble, so the S&P 500 was perilously close to that dubious honor a year ago. It was also only yielding 1.6% in dividends at the time, extremely low by historical standards. Just as January 2004's low VIX telegraphed, the markets were dangerously overvalued by any rational measure.
Today as 2005 is born, the S&P 500 valuations have indeed moderated a bit as Wall Street predicted. The index was down to 23.2x earnings, significantly lower than last year but still far above 14x fair value or the dismal sub-10x levels seen at Long Valuation Wave troughs every third of a century or so. The S&P 500's dividend yield barely budged to 1.7% today, pretty ironic since Wall Street predicted the dividend tax reductions would lead to a massive surge in cash dividends.
Today's decade-low implied volatility readings warning of extraordinary complacency coincide with a stock market that is still very expensive historically. And all this is happening in the descent phase of a Long Valuation Wave. Corporate earnings are indeed gradually rising, but they haven't risen anywhere near fast enough to justify the war rally since early 2003 or even the smaller election rally of late 2004.
Highly overvalued markets combined with extremely low fear are a recipe for disaster, as history has proven so many times before. If you are long the mainstream stock markets via significant direct investment or pension capital, you are betting against the entire weight of market history. Extreme VIX lows combined with very expensive earnings multiples are breeding grounds for bear markets, not spectacular new bulls. Please be careful here and realize the immense risks involved!
Today's no-fear environment glaringly evident in the flagship S&P 500 is still more pronounced in the hyper-bullish NASDAQ and its NASDAQ 100 VXN implied volatility index. The parallels between the chart above and this NASDAQ one really highlight the broad systemic danger here from zero fear combined with stellar valuations.
The market-darling NASDAQ's chart echoes the broader S&P 500's above, but with even more extremes. The 2004 downtrend prior to the election was even more pronounced in the remnants of the 1999 speculative mania. In 2004 to Election Day, the NASDAQ was actually down 1% on the year! But from the elections to year end, the index was up 10% making all of its gains in only the last two months. Once again an exogenous event not repeatable for four years has led to the questionable conclusion that 2004 was a good year for tech stocks.
Tech investors are so exuberant today that they have driven the VXN NASDAQ 100 implied volatility index to all-time lows. Granted, the VXN was only introduced in 2001 so it doesn't have the fabled multi-decade history of the VIX, but its current lows are still extreme. No fear is to be found anywhere in tech stock land as far as I can tell. And the immense prevailing complacency is combined with even more outrageous valuations, not a bullish sign.
One of the greatest lessons from the NASDAQ bust was that valuations matter. If you choose to buy an excessively expensive stock, you are virtually assured to lose money in the long term, period. At the end of 2004 just as complacency was waxing the highest though, NASDAQ valuations were staggering collectively and individually. As 2005 dawned the NASDAQ 100 was trading at a maniacal 42.2x earnings, far above the 28x bubble level. And it was only yielding a laughable 0.4% in dividends, even lower than the dismal anti-saver US interest rates.
Meanwhile all of the 10 largest stocks of the NASDAQ had individual valuations running from expensive to crazy. YHOO was trading at 99.7x earnings, EBAY at 110.2x, MSFT at 36.0x, AMGN at 38.2x, and DELL at 34.8x. These valuations are starting to remind me of the madness we saw in 1999, where investors were willing to pay so much for a stock that it would have taken the underlying company over 100 years just to earn back in profits the price they paid for the stock!
The NASDAQ faithful always scoff at the notion of valuations and sentiment actually meaning anything in their market because it is a "growth market". This defense is weak though. The biggest and most important NASDAQ stocks like MSFT and INTC are now mature companies that just don't ramp earnings like small growth stocks anymore. For example, neither of these two largest NASDAQ companies have any exciting new major products coming to market in 2005. In both cases they are merely eking out modest incremental improvements in their products and hoping that replacement computer and software demand will drive their bottom lines. Growth stocks they ain't!
Most of the largest and heaviest-weighted NASDAQ companies are like this, maturing without exceptional growth prospects. And later this year they will have to start expensing employee stock options too, dramatically slashing their reported earnings in some cases. The NASDAQ may have been a growth-stock market in the early 1990s, but it is generally not today. By market-cap it is primarily the home of large mature tech companies that have virtually no chance of growing profits fast enough to justify their staggering valuations.
And this brings us full circle. Whether in the broad markets or the market-darling tech sector, why are investors so overly confident today? Why have they driven fear to near-record or record lows and why are they so smug and complacent that 2005 is going to be a spectacularly bullish year with trivial downside risk? Do sentiment and valuations still matter or not?
I am certain they do still matter. From a contrarian perspective, the two most dangerous times to be long the markets are first of all when sentiment is extremely greedy and complacent and second when valuations are very high. Both major warning signs coexist today. The time the markets are most likely to fall is when the fewest people expect it.
As Warren Buffett has wisely said, the five most dangerous words any investor can ever utter are "This Time It Is Different." Investors betting on a massive new bull-market upleg launching today when there is no fear and valuations are obnoxiously high are declaring that this time it is different, that we are in a brave new era where the centuries-old laws of the markets no longer apply. This is the same cavalier attitude that led to the NASDAQ crash of 2000.
As a contrarian speculator, I will side with the weight of history over an unprecedented new era every time. I am carefully watching the VIX and VXN downtrends shown above and waiting for a breakout to signal a potential major new downleg brewing. Once these volatility indices break above their respective resistance lines the sky is the limit and we may once again taste what true fear is like in general equities.
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The bottom line is there is no fear in stocks today. Sentiment readings are at extremely complacent levels not even witnessed at the great bubble top of 2000 in some cases. Heck, even traditionally contrarian web forums are getting sucked up into the insidious bullishness pervading the markets thanks to the recent election rally. You have to be pretty heretical to even admit that there is a possibility for an ugly 2005 these days.
Yet, the markets are remarkably consistent in punishing investors in history for thinking like herds. Stocks tend to bottom just as folks are the most terrified and selling like crazy, and they tend to top just when people become so comfortable and complacent that they can't even conceive of potential plunges.
With the implied volatility indexes at such fantastically low levels today, the traditional warning signs of a major top are out there for all who are willing to see. Fear will return to stocks, sooner or later, as inevitably as night follows day. And only a sharp decline can reignite fear in the thundering herd to restore balance to sentiment.