The current stock market rally is well supported by strong trends, wide market breadth, a falling volatility range, and solidly improving economic fundamentals. Every single indicator that I use in my systematic Meta Strategy model (six fundamental & four technical signals) is showing green, which defines the current market regime as a Quiet Bull Market. Therefore, my base case is to stay invested and to expect positive returns over the long term.
This post concentrates on a detailed look at current conditions, which define the most likely short-term path to those long-term positive expectations. And here I see an increasing amount of red flags popping up, pointing to probable weakness over the next weeks.
The US stock market is overbought
The S&P 500 is overbought on daily, weekly, and monthly time frames, as prices are pushing above upper Bollinger Bands, paired with RSI (14) readings well above 70. This is happening while the index is trading just below a technical ceiling, which forms a rising trend line that has been insurmountable resistance for the past half-year.
However, overbought can easily become more overbought, and I would like to see additional, confirming indications. In fact, overbought readings can be used to construct successful trend-following models, rather than being solely useful as contrarian signals.
S&P 500 / VVIX correlation
Volatility measures rising in concert with equity indices are a warning that something is brewing beneath the surface. When the 5-day S&P 500 / VVIX correlation crossed above 0.7, we were warned of short-term stock market trouble throughout last year’s exceptional rally. This is one of my most reliable indicators for pinpointing when an overbought market might actually turn around.
Warning signals from a strongly positive S&P 500 / VVIX correlation led to an immediate sell-off last year in almost every single instance (blue lines in the chart), and no major market drop was missed. False positives warning signals (red lines in the chart) were rare. Only the reading in the beginning of October 2020 saw a significant continuation of a rally, but even then we soon reached lower lows preceded by a second, timely signal.
Long gamma exposure all-time high
Long gamma exposure has reached a new record high last week. When options market makers are long gamma, they exert a mean-reverting influence and suppress volatility, because they sell into a rising market (and buy into a falling market) to hedge their book. While initially stabilizing the market, extended volatility suppression increases market fragility, as it cannot be sustained indefinitely. (More on why gamma exposure and the options market matter here.)
Gamma exposure extremes, therefore are unhealthy, and they are highly correlated with negative returns over the next week. Large market drops are often preceded by big spikes in long gamma exposure.
As good as it gets
Widespread market breadth is a reliable sign for a strong bull market, but some readings are currently nearing their upper limits. The chart below (with the percentage of S&P 500 stocks that are trading above their 200-day moving average at nearly 96%) shows this quite clearly: While such extremely strong breadth readings are typical for the first strong rally in a fresh bull market, the following weeks or months often consolidate sideways or correct to gather new strength for the next run.
The persistence of a lower volatility range with the VIX trading below 20 has provided a major tailwind in the current market, as it is causing volatility-controlled funds to increase equity exposure. Any recent slack in retail participation was taken up by institutional demand, which has caused overall equity positioning to reach very high levels. Thus, we are in an “as good as it gets” environment, leaving a limited pool of potential buyers.
At the same time investors have largely given up on hedging their elevated equity exposure. This goes so far that we are seeing “anti”- hedging activity, as more puts are sold to open than bought — creating increased short volatility exposure. Such low levels of protection indicate a highly fragile market, because any catalyst could now initiate a scramble to buy hedging instruments, cover short put positions, or to raise cash, thereby starting a downward cascade.
Sentiment indicators have shown excessively high readings for months. Similar to overbought conditions, euphoric sentiment can stay high for extended periods of time and needs confirming indications to be useful. The current environment is buzzing with speculative energy, which has caused an elevated “sentiment regime”. My expectation is that we may well stay here for longer. As in the late 1990’s, market pullbacks cause sentiment indicators to retreat, only to bottom out at levels that are still historically high.
The Daily Sentiment Index has reached levels above 90%, which has been its historic high-water mark. As with breadth readings reaching their upper limits, such sentiment extremes are usually followed by a temporary cooling-off period within a strong bull market.
These data points are reason enough for me to expect significant stock market weakness over the next weeks or months. I am therefore hedging my investment portfolio and aim to profit from the short side in the near future. The beginning of a new bear market, however, is less likely, as all long-term indications remain positive.
Good luck with your trading, and thank you for reading!
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