Is there complacency in the stock market right now?

by Troy

While the stock market went nowhere today, various indicators are demonstrating some complacency in the financial markets. It would be a mistake to automatically assume that “complacency” = bearish. Knee-jerk reactions aren’t usually right.

Let’s determine the stock market’s most probable medium term direction by objectively quantifying technical analysis. For reference, here’s the random probability of the U.S. stock market going up on any given day.

*Probability ≠ certainty. Past performance ≠ future performance. But if you don’t use the past as a guide, you are blindly “guessing” the future.

Global Financial Stress Index – Skew

BofA Merill Lynch produces its GFSI (Global Financial Stress Index), an index that is supposed to help investors and traders identify market risks. From BusinessWire:

The GFSI composite index aggregates over twenty measures of stress across five asset classes and various geographies, measuring three separate kinds of financial market stress: risk, as indicated by cross-asset measures of volatility, solvency and liquidity; hedging demand, implied by the skew of equity and currency options; and investor appetite for risk, as measured by trading volumes as well as flows in and out of equities, high-yield bonds and money markets.

Let’s take a look at some of the GFSI components.

GFSI Skew tracks demand for protection against swings in global equities and currencies. When GFSI Skew is low, this is supposed to demonstrate “complacency” (a lack of demand for protection).

GFSI Skew is quite low right now. The last time it was this low was in January 2018, just before volatility exploded and stocks tanked.

Now before you think “the last time XYZ happened was (insert scary date here)”, please look at the entire data series. Here’s GFSI Skew from 2000-present

As you can see, this is quite common. GFSI Skew was consistently this low from 2000-2006, 2013-2014, and 2017.

Here’s what happens next to the S&P when GFSI Skew falls below -0.4 for the first time in 1 month

The stock market’s forward returns are mostly random.

Risk

Here’s the GFSI Risk Index. And once again, GFSI Risk is quite low.

Must be bearish for stocks right?

Here’s what happens next to the S&P 500 when GFSI Risk falls to -0.38 (first case in 1 month)

Actually, this is more bullish than bearish for stocks

Market Risk

Here’s the GFSI Market Risk Index. Quite low.

Here’s what happens next to the S&P when GFSI Market Risk falls below -0.95 (first case in 1 month)

Other GFSI

Here’s a quick look at the main GFSI Index and GFSI Liquidity Risk.

Click here if you want to download the GFSI data. I have placed the data into a ZIP file (if you want to play around with it).

Value Line Geometric Index

The Value Line Geometric Index is an equal-weighted index containing 1675 stocks from the U.S. and Canada.

Traders often look for “divergences” between an equal-weighted index and the market-cap weighted S&P.

The Value Line Geometric Index has diverged from the S&P 500 recently. “The last time this happened” was before the October 2018 crash. Surely this must be bad for stocks?

After all, this is how the 2000 bull market top started.

*Be careful when someone tells you “the last time XYZ happened was (insert scary date)”. That’s usually a marketing trick used to target your fear or greed. Objective traders and investors should look at the data holistically.

Here’s what happens next to the S&P when it rises more than 1.3% over the past 3 weeks while the Value Line Geometric Index falls more than -1.3%

This isn’t consistently bearish for stocks, especially 1 year later.

Dow golden cross

The Dow Jones Industrial Average has made a “golden cross”, whereby its 50 dma crossed above its 200 dma. These golden crosses are popularly seen as bullish indicators for the market.

Here’s what happens when you trade with the strategy:

  1. Buy on a golden cross (when the Dow’s 50 dma crosses above its 200 dma)
  2. Sell on a death cross (when the Dow’s 50 dma crosses below its 200 dma)

As you can see, this strategy is worse than buy and hold (although there is less downside volatility). Just because something is popular and has a catchy name doesn’t make it good.

Here’s what happens next to the Dow when it makes a golden cross.

Interestingly enough, the Dow has a slight short term bearish lean.

China

Like the Dow, China’s Shanghai Index has made a golden cross.

A like with the Dow, using “golden crosses” and “death crosses” actually underperforms buy and hold in the Chinese stock market.

VIX death cross

VIX recently made a “death cross”, whereby its 50 dma fell below its 200 dma.

This is mostly a random indicator for the S&P and VIX.

Robert Shiller

Robert Shiller was on CNBC recently predicting that there’s a >50% chance of a recession over the next 18 months, which explains his bearish stance on stocks.

I highly respect Robert Shiller for his work with financial data. But anyone who has followed Robert Shiller over the years knows that his market calls have been worse than a 50/50 coin toss.

Moral of the story: be careful when listening to your favorite guru. Always think for yourself. Never lean bullish/bearish just because someone else is bullish/bearish, no matter how smart that person is or how many Nobel prizes he has won. (Even Isaac Newton lost a fortune in the South Sea bubble).

A quick trip down memory lane:

In 2011:

In 2013

In 2014

In 2015

In 2017 (this complete turnaround is actually quite funny because it happened within 3 months)

February 2017

May 2017

September 2018

In my opinion, Robert Shiller’s mistake is his complete reliance on valuation indicators (which pretty much explains everyone who has missed out on this bull market). Yes, valuations are “high”. But the average valuation over the past 25 years has been consistently higher. There is a paradigm shift in average valuations because interest rates are lower.

Click here for yesterday’s market analysis

Conclusion

Here is our discretionary market outlook:

  1. The U.S. stock market’s long term risk:reward is no longer bullish. In a most optimistic scenario, the bull market probably has 1 year left. Long term risk:reward is more important than trying to predict exact tops and bottoms.
  2. The medium term direction (e.g. next 6-9 months) is more bullish than bearish.
  3. The stock market’s short term has a bearish lean due to the large probability of a pullback/retest. Focus on the medium-long term (and especially the long term) because the short term is extremely hard to predict.

Goldman Sachs’ Bull/Bear Indicator demonstrates that while the bull market’s top isn’t necessarily in, risk:reward does favor long term bears.

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