I’d argue that the record low volume shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible people.
The above are edited excerpts from an article* by Jesse Felder (thefelderreport.com) entiltled The Calm Before the Storm.
The following article is presented by Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and the FREE Market Intelligence Report newsletter (register here; sample here) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.
When volatility gets as low as it has recently I take it as a sign of dangerous complacency, especially with the growing potential risks to stocks right now…Over the past 25 years there has only been one other period where volatility has been as low as it is today: July 2007, and prolonged periods of low volatility actually create more extreme, pent-up volatility. It works like this:
A stock market that goes months and months without anything more than mild pullbacks causes investors:
- to be lulled into a sense of security or confidence that stocks just don’t go down anymore,
- to extrapolate the recent benign price action far out into the future,
- to start believing things like the “great moderation” line of bullshit’,
- to become overconfident and over-commit to stocks,
- to become surprised by the ‘extreme volatility’ when a pullback greater than just a few percent finally happens (which is really just normal volatility that has been dormant) and
- to reduce the undue exposure they put on when they believed volatility was dead.
Add this to the normal selling that occurs and you get a greater than average sell off. Multiply all of these effects (to account for record low volume) from the beginning and that’s how you get a crash like we saw subsequent to the record low volume mid-2007. While there were all sorts of other issues that compounded to create the worst financial panic in a few generations that’s not about to happen again, but history does look like it could be rhyming in some ways right now.
High Margin Levels
…Jeff Gundlach has warned that when record high margin debt finally, and ominously, begins to reverse we could expect a double digit decline…and @jlyonsfundmgmt shared a great chart the other day showing the correlation between margin debt and the peaks of the past few bubbles.
I know: Correlation ≠ causation, but it still makes a great deal of sense to me that margin debt is greatly responsible for blowing up an equity bubble in the first place and when it peaks it’s a good sign that the bubble has run out of fuel.
Small Cap Weakness
We’ve seen some canaries croaking in this coal mine over the past couple of months. Biotech stocks, MoMos and the Russell 2000 have all taken it on the chin lately even while the major indexes have hovered near their all-time highs. @ukarlewitz noted late last week in his excellent “Weekly Market Summary” that, “At more than 5 years, the current bull market (defined as a gain uninterrupted by a drawdown of more than 20% on a closing basis) is both longer and more powerful (on an inflation-adjusted basis) than either the one from 1982-87 or 2002-07. It is, in fact, longer than every bull market in the past century except the ones ending in 1929 and 2000. In other words, this exceptionally long advance without a 10% correction is occurring at the point where virtually every bull market has already ended.”
No, this doesn’t mean stocks are about to fall 20%+, but with record low volume over this span how many investors are prepared for such a scenario?
There are also divergences galore…
- [There is] weakness in the banks along with the small caps in contrast to the majors.
- Maybe more important is what the smart money is doing. We haven’t seen a divergence this large between “emotional buying” and rational buying since – you guessed it – 2007.
- Another noteworthy divergence/canary can be seen in junk bonds. Risk appetites there have also begun to reverse and this is typically a prelude to equity risk appetites reversing as well.
So what to junk bond investors see that equity investors don’t?
- Maybe it’s that the latest episode of “reaching for yield” is about to come home to roost.
- Maybe it’s the weakness in retail. TJX, HD, WFM, BBY, PETM and others have all disappointed investors over the past couple of weeks and we all know consumers make up 70% of the economy.
- Maybe it’s the bursting of the bubble in profit margins.
- Maybe it’s the bursting of the housing bubble in China.
- Or maybe it’s just the fact that this cycle has run its course and is about to swing the other direction.
In any case, I’d argue that the record low volume shows investors aren’t looking ahead as much as looking behind and reminiscing at how good things have been over the past five years or so. They’re expecting more of the same even though it’s mathematically impossible people love to believe things even when they know they’re not true and, you know what, according to the Fed, this is the very definition of a bubble.
It might not be your father’s bubble but just because we haven’t matched the p/e’s achieved during the internet bubble doesn’t mean that we aren’t ridiculously overvalued today – and it’s increasingly likely this is just the calm before the storm.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://thefelderreport.com/2014/05/23/the-calm-before-the-storm/ (Copyright © 2014 Felder & Company, LLC, All rights reserved.)
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