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SPX Topping Extremes

By: Adam Hamilton, Zeal Research


-- Posted Friday, 17 May 2013 | | Disqus

The levitating stock markets continue to seductively entrance traders, powering to new nominal record highs day after day after day.  No one believes a meaningful selloff is even possible anymore, thanks to the vast deluge of central-bank monetary inflation.  Sheer euphoria has set in as all perception of risk has vanished.  This makes these stock markets extraordinarily dangerous, they are truly at topping extremes.

 

As of Wednesday, the flagship S&P 500 stock index (SPX) had rallied to new nominal record highs in 11 of the past 13 trading days.  It blasted 4.8% higher over this short span.  If sustained for an entire year, this blistering rate of ascent would nearly double the stock markets!  This latest euphoric surge extended the cyclical stock bull that was born way back in March 2009 to a massive 145.2% gain over 50.2 months.

 

This move, particularly the one-sided 22.6% melt-up in the last 6 months, has bred unmistakable euphoria.  Wall Street vehemently tries to deny this truth, but the definition of euphoria is ďa feeling of great happiness or well-being, a feeling of great elationĒ.  Does that not describe the outlook for the stock markets today?  There are no bears left, everyone is incredibly bullish and expects no material selloffs.

 

Normal healthy bull markets climb a literal ďwall of worryĒ, traders are always anxious about some catalyst arising that will spark a sharp selloff.  But not today.  The markets have run up for so long with nary a hiccup that traders no longer believe significant selloffs are even possible.  They expect any selling to be met with immediate buying, effectively backstopped by the Fedís unprecedented QE3 debt monetization.

 

All news is being interpreted as bullish today, thanks to the Fed manipulating the markets.  If it ramps up QE3, then there will be more freshly conjured money pouring into stocks.  If it instead tapers QE3, then the underlying US economy must be improving so cash on the sidelines will return.  And of course any poor economic news is seen as forcing the Fed to keep aggressively monetizing debt, again bullish for stocks.

 

But all markets flow and ebb.  Prices rising and falling is the natural order of things.  This is because nearly all short-term price action is driven by the perpetually warring emotions of greed and fear.  These are mutually exclusive, so prevailing market sentiment swings back and forth between them like a great pendulum.  Excessive greed is followed by excessive fear, as the markets always ultimately balance out.

 

Euphoria, which is built on rampant greed, is the most tell-tale sign of a major topping underway.  Traders no longer worry about anything, so their greed drives them to buy every trivial dip.  This pushes markets higher and higher regardless of newsflow until everyone interested in buying in anytime soon has already bought in.  That leaves only sellers, so the great sentiment pendulum starts swinging back.

 

I suspect that very peak-euphoria moment is here, when the SPXís anomalous uptrend suddenly reverses.  Contrary to popular belief, this doesnít require a news catalyst.  Once all available near-term buyers are sucked in, sellers assume control by default.  Most bull markets top without any crisis or even bad news to spark the initial selling!  And that quickly feeds on itself as late buyers rush to cut their losses.

 

Pretty much every technical or sentimental indicator you want to look at these days confirms the euphoria blinding stock traders.  Last week I focused on the excessive valuations, stocks are very expensive so the foolish traders chasing this topping are buying high.  This week Iím examining psychology, the extraordinary greed and complacency driven by a one-sided melt-up.  And its resulting overboughtness.

 

This first chart looks at the benchmark S&P 500 in blue and its definitive sentiment gauge, the VIX implied-volatility index, in red.  The span encompasses the SPXís entire mighty cyclical bull market since March 2009.  Against this backdrop I noted every pullback and correction this stock bull has witnessed.  We havenít seen either now for record durations in this bull, another warning sign of rampant euphoria.

 

 

Pullbacks and corrections are perfectly normal in, and indeed essential to, healthy bull markets.  Bulls die when greed morphs into euphoria and all available buyers are sucked in.  Pullbacks and corrections act as critical psychological safety valves to bleed away greed before it builds to bull-slaying excesses.  And that is exactly what has happened in the past 6 months totally devoid of any material selloffs at all.

 

Stock-market selloffs come in different sizes.  The smallest are less than 4%, and arenít considered material.  They usually consist of a few down days that quickly reverse.  Bigger ones from 4% to 10% are classified as pullbacks.  They are common within ongoing uplegs, scaring away greed so the upleg can continue higher with rebalanced sentiment.  And the largest selloffs over 10% are known as corrections.

 

Corrections donít occur within uplegs, but between them.  Greed grows excessive enough after major uplegs that a serious injection of fear is necessary to restore balance.  And only sharp and large selloffs can introduce real fear.  These corrections run between 10% and 20%, and generate so much fear that the majority of traders wrongly assume the bull is over.  And anything above 20% is a new bear market.

 

Note in this cyclical bullís chart that pullbacks have been fairly common.  There were 10 selloffs between 4% and 10% from March 2009 to November 2012, a 44-month span.  Add in the 2 full-blown corrections between uplegs, and that is a dozen major selloffs.  This averages out to one every 3.7 months or so.  Today we are up to a bull-record streak of 6.0 months without even a single pullback or correction!

 

Instead all the SPX has had to weather were 3 trivial selloffs that were too shallow and too short to have any impact on the rapidly growing greed seducing traders.  In late December on fiscal-cliff uncertainty the SPX retreated 3.1%.  In late February on Italian-election-stalemate-driven Europe fears it gave back 2.8%.  And most recently mid-Aprilís unprecedented futures-driven gold panic dragged the SPX down 3.2%.

 

But sub-4% selloffs are simply not big enough to catch marketsí attention.  Such modest moves lower donít even faze traders, they are quickly shrugged off.  The bigger and sharper any selloff, the more fear it generates and the more greed it eradicates.  Small selloffs actually have the opposite effect, multiplying greed and complacency as traders start assuming markets have entered a new era of bulletproofness.

 

Itís been a whopping 6.0 months since the SPX has even seen a pullback and an incredible 19.4 months since it has weathered an actual correction!  Such long spans have never before happened in this bull.  The previous pullback-devoid record was 5.8 months ending in February 2011.  And soon after that melt-up, that SPX upleg decisively topped and the biggest correction of this entire bull market was born.

 

It pummeled the stock markets 19.4% lower over 5.2 months, although over 5/6ths of its losses happened during a brutal 2-week span in the middle.  Provocatively that was during the last serious Congressional fight on excessive government spending, when gold skyrocketed dramatically.  The next debt-ceiling battle is right around the corner, and it too probably bodes bearish for overbought stocks and bullish for oversold gold.

 

Since that last correction, which I warned about in advance, the SPX has gone an astounding 19.4 months without one.  That compares to 13.5 months before this bullís first correction, and 9.9 months between its first and second.  It is worth remembering that both those previous corrections occurred in lulls between the Fedís quantitative-easing campaigns, so any reduction of QE3 is not bullish for stocks.

 

Even the most vociferous bulls out there have to acknowledge that periodic pullbacks and corrections are necessary for healthy bull markets.  Excessive greed simply has to be vented from time to time, or it will multiply until it smothers the bull.  And obviously today it has been far too long since weíve had either a pullback or a correction, so greed is out of control.  The bulls should be praying for a material selloff.

 

One of the key byproducts of widespread greed is complacency.  It is ďa feeling of contented self-satisfaction, coupled with an unawareness of dangerĒ.  When stocks melt-up and levitate sans-selloffs, traders start to erroneously think they are impervious to any selling catalyst.  These Teflon markets are celebrated, yet it is exactly these times when a topping is underway and a wicked correction is imminent.

 

Greed creates complacency, and the opposite of greed is of course fear.  The implied-volatility indexes like the VIX effectively measure fear by looking at optionsí traders collective expectations for the swiftness of upcoming SPX moves.  Greed and fear are very asymmetrical.  The former grows gradually and slowly drives up prices, while the latter flares rapidly and ignites sharp universal selling that hammers prices.

 

So while a high VIX shows widespread fear, the ideal time to buy low, a low VIX reveals the opposite sentiment extreme which is widespread greed.  Note that just before each of the previous major corrections of this cyclical bull the VIX slumped to very low levels as the SPX topped.  This low volatility was effectively signaling high complacency.  Smug traders full of hubris didnít have a care in the world.

 

Previous major tops in this bull just before its corrections and largest pullback saw the VIX slump down to 15ish levels before triggering major selling.  But complacency has grown so extreme this year thanks to the SPX melt-up that the VIX has slumped into the 11s and 12s.  These are truly bull-slaying levels of complacency betraying extreme greed.  Seeing the VIX so low while the SPX is so high is a huge danger sign.

 

If you want to dig deeper into implied-volatility lows and major corrections, I wrote an essay on high stock complacency earlier this year.  Market history is crystal-clear, when traders think there are no more risks and stocks are going to levitate indefinitely is exactly when the worst selloffs are born.  It is just crazy to buy stocks high after long runs devoid of rebalancing selloffs while the VIX is exceptionally low.

 

Another tell-tale sign of a major topping underway is overboughtness.  There are limits to how far and fast any market can rise or fall.  If a market rises too far too fast, greed grows excessive, all potential buyers are sucked in, and control is surrendered to sellers.  The SPXís extraordinary surge over the last few weeks has catapulted it to extremely overbought levels.  It has simply rallied too far too fast to be sustainable.

 

By what standard?  Its own cyclical bullís!  Many years ago I developed a trading system I called Relativity.  It looks at how far and fast a price has moved relative to an objective and gradually-evolving baseline, its own 200-day moving average.  In any trending market, the multiple derived from a price divided by its 200dma charted over time yields a horizontal trading range.  The SPX is no exception.

 

This last chart looks at this Relative SPX (rSPX) trading tool for this cyclical bull.  It is shown in light red with the SPX itself superimposed on top in blue.  Throughout this cyclical bull, the SPX has generally traded in a range between 0.90x to 1.10x its 200dma.  Whenever it creeps above the 1.10x overbought resistance line, which it has again recently, a full-blown correction soon follows to rebalance sentiment.

 

 

Just this week, the SPX stretched to 1.12x its own 200-day moving average!  Seeing the SPX more than 10% above its 200dma is pretty rare, and 12% is truly extreme.  Whenever this broad benchmark index surges far enough and fast enough to hit such levels, its advance is not sustainable.  Excessive greed has pushed the markets to a level where buying exhaustion emerges, so the stock markets fall sharply.

 

The last time the SPX stretched 12% above its 200dma was back in March 2012.  While we didnít see a correction after that extreme overboughtness, the biggest-possible pullback soon started.  The SPX would retreat 9.9%, just a hair away from official correction territory.  But given the rampant euphoria today, I really doubt traders will be so lucky to merely get a large pullback.  Even that would still wreak sentiment havoc.

 

Complacency is so crazy now that most of the analysts and elite money managers on CNBC are saying they expect no selloff greater than 2% or 3% before new buying floods in to erase it.  That is exactly what weíve seen in the past 6 months, and they donít expect this trend to change.  So when the inevitable coming selloff gets up in the high-single-digits range, it is going to terrify everyone and snowball into a correction.

 

Back in early 2011 the rSPX shot as high as 1.152x, but that anomaly was very short-lived.  That final spurt higher happened over 5 weeks after 1.12x was first hit.  But the more overbought any market becomes, the bigger and sharper the necessary subsequent correction to eradicate the greed and rebalance sentiment.  And indeed the SPXís biggest and fastest correction of this entire bull occurred soon after.

 

So if the dumb euphoric buyers somehow continue driving the SPX even higher relative to its 200dma in the coming weeks, it just guarantees an even bigger and sharper selloff.  Before that 2011 correction, the last time the rSPX exceeded 1.12x was back in April 2010.  And immediately after that this cyclical bullís first correction was born, a sharp 16.0% plunge.  Such rSPX extremes are absolutely topping signs!

 

The SPXís overboughtness should be evident to all traders even if they havenít studied what happens after this index stretches 12%+ above its 200-day moving average.  Even simple technicals reveal the euphoric surge.  Check out this cyclical bullís uptrend in the chart above.  This year was the first time in this entire bull the SPX has soared above its cyclical-bull uptrendís resistance, a very overbought state!

 

Whenever any market is very overbought by its own standards after a long rally that was uninterrupted by any material sentiment-rebalancing selloffs, prudent traders have to expect a sharp correction.  After all, thatís what markets do.  They rise and they fall.  The SPX has rallied too far too fast for too long, resulting in euphoric sentiment.  And as always when such extremes are hit, the inevitable reckoning soon follows.

 

So how big will the selloff be?  The odds are approaching certainty that it will at least exceed 10%, formally hit correction territory.  And if this long-in-the-tooth cyclical bull is to survive any longer, the bullish traders should really hope for a major correction approaching 20%.  It is going to take a lot of selling to bleed away enough greed for any semblance of balanced sentiment to finally return.

 

I suspect the selloff will ultimately prove a lot bigger than that, a formal new cyclical bear market.  The stock markets have languished in a sideways-grinding secular bear since early 2000.  These beasts are a series of cyclical bears which cut stock prices in half followed by cyclical bulls which double them to breakeven again.  Our current secular bear hasnít lasted long enough and valuations are still far too high to end it.

 

So ever the contrarian, I am betting that the euphoria weíve seen in 2013 marks the topping of this cyclical bull before stocks roll over into a new cyclical bear.  We wonít know for sure until the necessary selloff exceeds 20% and formally enters bear-market territory, but that is the highest-probability outcome by far based on historical stock-market cycles.  And virtually no one expects a new cyclical bear today.

 

At Zeal we are ready.  Weíve spent decades painstakingly studying the markets.  Weíve been watching this topping unfold for many months, but have held back on taking action since these events often take some time to unfold.  But just this week the overboughtness and euphoria finally grew excessive enough to start formally recommending short-side trades in our popular weekly newsletter for contrarian speculators.

 

We also publish an acclaimed monthly newsletter for contrarian investors.  These valuable publications offer a priceless battle-tested contrarian perspective that is exceedingly hard to find.  They draw on our deep experience, wisdom, knowledge, and ongoing research to explain what is going on in the markets, why, and how to trade it as opportunities arise.  You canít buy low and sell high until you fully integrate contrarianism into your trading approach.  Subscribe today!

 

The bottom line is the stock markets are topping today.  The flagship S&P 500 is hitting all kinds of technical and sentimental extremes only seen at major toppings.  Euphoria now reigns supreme as traders no longer think anything beyond the most trivial selloff is even possible anymore.  But this is exactly when serious major selloffs are born, when traders grow so complacent they stop worrying at all.

    

Thus these beloved stock markets are extraordinarily dangerous.  Best case we are in for a humdinger of a correction, worst case a new cyclical bear.  Investors need to short-circuit their own greed and realize their profits before the selloff eradicates them.  Speculators should close general-stock longs and start initiating shorts if they havenít already.  The looming major selloff will gut the gullible fools who bought high.

Adam Hamilton, CPA

May 17, 2013

 

So how can you profit from this information?  We publish an acclaimed monthly newsletter, Zeal Intelligence, thatdetails exactly what we are doing in terms of actual stock and options tradingbased on all the lessons we have learned in our market research.  Please consider joining us each month fortactical trading details and more in our premium Zeal Intelligence service at Öwww.zealllc.com/subscribe.htm

Questions for Adam?  I would be more than happy to address them through my private consultingbusiness.  Please visit www.zealllc.com/adam.htm for moreinformation.

 

Thoughts, comments, or flames?  Fire away at zelotes@zealllc.com.  Due to my staggering and perpetuallyincreasing e-mail load, I regret that I am not able to respond to commentspersonally.  I will read all messagesthough and really appreciate your feedback!

Copyright 2000 - 2013 Zeal Research (www.ZealLLC.com

 

 

 


-- Posted Friday, 17 May 2013 | Digg This Article | Source: GoldSeek.com

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