And just like that, the bulls are quieter. After listening to them ridicule anyone who suggested that risks were increasing, suddenly anyone who has bought stocks during the last month is at best break even, but more likely, underwater.
The bulls’ overconfidence was in some ways understandable. For the last couple of years the stock market has been remarkably bullet proof. It seemed like no matter whatever bad news was thrown at it, the stock market kept chugging higher. The bull market made geniuses out of everyone who had the guts to just “go for it.” It also skewered anyone who was stupid enough to stand in front of the wall of money that was flooding the market.
The MacroTourist standing in there shorting stocks</a> </div>
During this relentless rise, the bulls’ confidence had reached such a feverish pitch that they openly mocked anyone who was not “smart enough” to be fully invested. Their cockiness finally drew the ire of the Market Gods who last week unleashed a solid downdraft.
S&P 500 trading over past week</a> </div>
Although last week’s stock market carnage was ugly, the bears should by no means be taking a victory lap just yet.
S&P 500 trading over last 2 years</a> </div>
The massive upward trend is still very much intact.
The real question is whether this will be a small refresher to cleanse out an extremely overbought condition, or whether this is the start of something more ominous.
No one can say that there weren’t warning signs that stocks were vulnerable. Small cap stocks had been trading poorly for some time. In fact going into last week, although the S&P 500 was hitting new highs (up 7% for the year), small cap stocks were actually down on the year (down 2%).
Russell small cap (white line) vs S&P 500 (yellow line) before last week</a> </div>
The question of whether small caps were going to rally to catch up to the large cap, or whether large caps were going to follow small caps lower was finally answered.
Russell small cap (white line) vs S&P 500 (yellow line) including last week</a> </div>
What I find most amusing is that how now that the selloff has happened, everyone “knew” this was coming. I sure wish I was as smart as all of these bulls that somehow all timed their bearishness perfectly. I have been unsuccessfully trying to time the decline for at least a month. Although I ended up being right, my early bearishness shows the difficulty in taking money out of the market. This might be the greatest game ever, but it sure is hard.
This tendency for traders to rewrite their personal history is as old as the hills, so I shouldn’t be too surprised that my twitter stream is filled with bulls who magically “knew” a correction was coming. And I am sure that I am probably guilty of this in some regards as well, but it never ceases to amaze me how quickly the sentiment shifts.
The real question is where are we going from here?
Although I will acknowledge that we are now very oversold on the short term charts (and due for a day or two bounce), I believe that the trend has changed. The largest cap stocks are still up on the year, but there are a lot of stocks that are now down on the year. Many stock investors are going to find themselves offside on their purchases from the first half of the year. Rallies will be used as lightening up opportunities as opposed to dips being used as chances to add to positions.
I have been fighting the rise in the stock market for too long, and the worst thing that I could do is to not recognize when the trend has changed and thus fail to capitalize on the position. All too often I fail to realize that trends take way longer to play out than I anticipate. The extent of the recent rise was much more intense than I forecasted, and the same will be true of the decline.
In the coming days and weeks, there will be rallies that briefly re-ignite the bulls’ hope that the good times have returned, but don’t be fooled by them. They will be fleeting. The rise shall be met with selling. It might take a day before it kicks in, but don’t trade with the idea that stocks will resume their march to new highs.
We have experienced a change in psychology. I have written about how there will not be enough exits on the way out – this is your chance to safely find a way out of the theatre.
Warning clouds from high yield?
There has been a lot of talk about the recent poor price action in high yield debt. I dug up a chart of the BarCap US Corporate 10 year High Yield spread index to demonstrate the recent sell off. It measures the difference between high yield and the risk free government rate.
BarCap US Corp High Yield Spread Index</a> </div>
There can be no doubt that the last month has seen a big move off the lows. But the problem about reading too much into this move is that the yields on high yields had reached such ridiculously tight levels, there really was no where for them to go but up. When you step back and look at the bigger picture, the recent backup is not quite as serious.
BarCap US Corp High Yield Spread Index – 5 year chart</a> </div>
However, maybe you could argue that just like the fact that high yield was priced for perfection, so too are stocks. Maybe stocks are priced so aggressively that they will be prone to disappoint – just like high yield.
Stocks and high yield often move together. Here is the chart of the S&P 500 versus the inverted BarCap spread.
S&P 500 (yellow line) vs Inverted BarCap (white line)</a> </div>
I don’t know if this is a pause in high yield, or the start of some real selling. But I do know that summer months are often illiquid periods where panics can snowball. There has been a tremendous amount of money that has been chased out the risk curve. A lot of it has actually found its way into fixed income ETFs. I have written about how these ETFs are a disaster waiting to happen.
Maybe between the end of QE and the fact that the Fed’s move off of ZIRP is finally being priced into the markets, the walking back to safety is starting to occur. If that is the case, then this process has barely begun. Have a look at an updated chart from the post above that I wrote a few months ago.
BKLN price (white line) vs Shares Outstanding (yellow line)</a> </div>
I am not predicting that this is going to get worse, but I do know that buying the dips will be extremely dangerous. If this unwind does accelerate to the downside, then buying too early will be the mistake – not the other way round.
Switching long VIX into short Stocks
I have been fortunate to be long a decent slug of VIX. This recent stock market sell off has caused a fairly large move off the lows.
VIX chart</a> </div>
I am still not a huge long term VIX bull and think that the real fireworks of any sell off will emanate from fixed income. Therefore I am going to ring the register on this long VIX trade over the next day or two. I will be selling my VIX and replacing it with more outright short stock indexes.