Mid-week market update: As the stock market grinds upward, I am seeing different variations of “it’s a little too quiet out there” warnings from market analysts. One example is the growing gap between the implied volatility (IV) of the S&P 500 and the historical realized volatility (HV).
Eventually, something has to give. It usually ends with a spike in IV, or VIX, which has an inverse relationship with stock prices.
This Will Not End Well
Willie Delwiche recently voiced a similar warning of how corrective actions tend to end periods of low realized volatility.
Here is another showing previous episodes (n=2) when SPY 90-day realized volatility fell to such levels in September 2018 and January 2020.
The U.S. equity market is experiencing a record level of retail buying, which is contrarian bearish.
I could go on, but you get the idea. These warnings, however, represent condition indicators, or “this will not end well” warnings with unknown triggers.
The Bearish Trigger
I am on record as intermediate-term bullish, but the market is extended and it can pull back at any time. But where’s the bearish trigger for a correction?
A review of my equity risk appetite indicators presents a mixed picture. The relative performance of high beta to low volatility stocks is tracking the upward grind in the S&P 500. On the other hand, the relative performance of consumer discretionary to consumer staple stocks (green line) is showing a minor negative divergence. An extended U.S. federal government shutdown could dent consumer confidence and further depress the consumer discretionary stocks.
The accompanying chart shows another possible bearish trigger. It’s highly unusual for the 10 dma of the equity put/call ratio to be this low. In the past, whenever this ratio began to turn up from such depressed levels, a pullback of unknown magnitude has followed.
For a more definitive test, I would wait for the combined violation of the 20 dma by both the S&P 500 and the equal-weighted S&P 500 to determine whether a pullback has begun.
I maintain the view that, in light of strong fundamental and price momentum, the intermediate-term trend is still up and any weakness should be viewed as a buying oppotunity. My base case is penciling in a 5-10% discount from the most recent market peak.
What if we get a worsening inflation print and jobs come in with good #s ? Then the Fed might not cut. That could trigger something. In any case, my guess is the trigger will be something unexpected.