Now that cash holdings are beating the stock market gains for 2018, “Goldman Says It’s Time for Equity Investors to Boost their Cash”(11-20-18). Headlines from Goldman Sachs, Wells Fargo and many analysts warn that investors should not Buy the Dips and remain defensive. Anecdotally this is one of the more Alarmist mantras we have heard in years. The perspective by these esteemed analysts is the lack of panic and need for more Put option buying, a much higher volatility index (VIX>35) and some indiscernible degree of wholesale panic are required before it’s safe to haul cash out of the foxhole and add equity exposure. The irony is that so many professionals claiming a need for more pessimism is a hint that extreme pessimism is already here. If the experts are so Bearish as to dismiss the 11% correction we just had as being too complacent, then maybe these Bears have already sold and have become too negative. The concept of contrary opinion holds that if the majority have one view then the opposing view will prevail. The masses never realize that negativity and selling have reached a climax when it finally happens, which greatly increases the odds that a new rally is near.
CNN’s Fear and Greed compilation of indicators certainly counters the notion that extreme Fear is absent over the past month. Only a few brief spikes in this index have ever registered more Fear in its 8 year history. Historically after a 10+% correction with this index in the oversold zone under 20 for over a month, we typically witness higher stocks in the next 1 to 3 months.
A survey of Chief Financial Officers (CFO) is also more fearful than in the equivalent sized correction back in February. Despite the almost 12% correction in the SP 500 and over 16% in the tech heavy Nasdaq, most CFO’s expect the next 2,000 points to be lower before we go higher.
Traders and hedgers buy more Calls in expectations of higher prices and purchase more Put options when expecting lower prices. We always see extreme Put buying at stock market lows. How low is low we can never now exactly as each correction is of a different amplitude and psychology. However, there is no denying that the Put/Call ratio reveals the most negative reading in over 15 months and the 3 standard deviation move from optimism to pessimism correlates with previous correction lows. Trader Put option buying has room to rise still further, especially if US and China trade talks reach a new level of dysfunction at their early December meeting triggering more downward revisions to 2019 earnings expectations.
Volatility (VIX) rises as the stock market falls and reaches an extreme when the momentum low for the stock market correction peaks. Our contrarian sense is that VIX is better known than anytime in history and market pundits stating the need for a VIX in the mid 30’s to 40’s before stocks can bottom may be a sign that it will not occur. If consensus expects a higher VIX (lower stock prices) then they have already done most of their selling, reducing the odds of a further market panic without a significant exogenous news event (new tariffs). While a VIX near 40 would be a sign of panic and a clarion call to increase your equity exposure, it may already be discounted and stay subdued in the 20’s. It’s also worth noting that viewing this year as part of a larger corrective phase, as in 2015 – 2016, we observe that the initial VIX spike in the first leg lower for stocks is significantly reduced during the 2nd wave. In early 2016 the SP 500 fell over 14% with a VIX peak near 28. The current correction in stocks of 11% witnessed a peak VIX of 26. Negative news on the China trade front may provide the expected VIX spike most are waiting for, but perhaps it will not arrive in this gift wrapped package at all. If the VIX spikes further it will find a way to fool the majority and last longer at higher levels than money managers forecast.
One of the biggest impediments to sustained market gains into year end is the China trade deal status. The challenge for 2019 is the strong risk of slowing US growth and potential earnings downgrades to which an escalating China Trade War would exacerbate. If the US GDP slows from the 3 or 4% range closer to 2% in 2019 and earnings growth of 10% now expected falls to a more realistic 3 to 5%, then stocks are already above fair value for next year with significant risk of a further 10 to 15% correction from here. Sewing this risk into the extreme fear levels we see out there stitches together a picture of limited duration rallies until interest rates come down and the global trade picture improves. The good news is that if indications of a slowing US GDP start popping up, Fed Chairman Powell will announce a pause in the 2019 rate hike plans and provide solace to stock market investors. Any hint from the early December meeting between Xi and Trump of a future trade deal will also send stocks surging higher and unfortunately the converse is also true. Some clarity should arrive in December, but the observation in the charts above is that pessimism on the near term outlook has already reached an extreme that increases the odds of a market bottom and with so many expecting more panic, the odds favor a rally phase barring exogenous events.