Odds of a Stock Market Pullback — Unprecedented VIX Volatility

The article below went out to subscribers of The Insider yesterday. This is an email that goes out to all paying subscribers (for no extra charge) three times a week. Given the recent craziness in the market, I think it’s an important message, and I wanted to share it with you today.

Enjoy…

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Talking about near-term market direction is fraught with danger.

The advice you take on board and decide to action will depend much on the type of investor you are: Long-term investor versus short-term trader etc.

So keep that in mind when you read today’s essay. I’m going to reproduce excerpts/opinions from our most experienced investors/traders. There is a consensus of opinion amongst us that is a little unusual.

We arrived at this consensus not through discussion. I purposefully ban any talk about ‘the market’ in our weekly meetings. I encourage discussion of opportunities and threats, but not ‘where do you think the market goes from here?’. It’s an unproductive discussion that can often lead to groupthink.

So the fact that a number of us have arrived at the same point independently is a bit of a concern.

Have We Hit the Bottom? Financial Expert Warns Not Yet. Learn More.

As you know, volatility returned to the stock market sharply last week. But this week the market rallied strongly. It’s like last week’s issues never happened.

But first, I’ll start with Ryan Dinse’s view. He wrote the following last Thursday in his Small-Cap Momentum Alert, in response to the Wall Street short squeeze antics around GameStop and other heavily shorted companies:

Maybe this is just an interesting little anecdote. A legendary trading tale for the ages.

And in isolation it would be.

But my worry is it’s a growing sign of investor overconfidence.

Every bull market top has such a moment; when everyone thinks it’s easy to make money trading in stocks.

If I’m honest, I’m hoping we get some sort of pullback, as it will actually set us up for some good trade opportunities at better prices.

As a trader you need ebb and flow in prices, not just flow!

But don’t worry, if a pullback doesn’t come, there’ll still be opportunities to find trades in the right sectors at the right time.

Anyway, they’re my thoughts for the moment and as a nimble trader I reserve the right to change my mind!

I wrote my weekly update for Crisis & Opportunity subscribers on Monday evening and early Tuesday morning, warning them to prepare for more volatility:

I could be wrong of course, but it feels like the mood of the market is about to change. Last week’s speed bump could be a sign of things to come.

There are a whole bunch of reasons for that. But I’ll distil it down to something simple: Everyone is on the same side of the boat. When that happens, you need to be careful.

To be honest, everyone has been on the same side of the boat for a few months now. But last week’s shenanigans with social media punters trying to engineer short squeezes exposed the fragility of leveraged hedge funds and raised the issue of counterparty risk.

That’s a long way of saying that in the future, the market might not be as complacent as it has been.

In the long-term scheme of things, whether the market corrects 10%, 15%, or 20% in the next few months, is neither here nor there.

It would be easy just to tell you to ignore it. In fact, I’d like to ignore it too. I don’t really want to make predictions of where ‘the market’ might be headed, because it’s a low-probability game.

But I think from an emotional standpoint, it pays to be prepared for a short-term drawdown. It’s better to accept that a 10–20% decline is likely, rather than be caught unaware and panic-sell at the wrong point.

I don’t think you should sell and wait for a decline though. The way to make really big gains is to be able to endure the inevitable corrections and be there for the rebound. Plus, I could be completely wrong. The speculative fervour could continue.

The best option for you is to be aware of the growing probability of a decent decline playing out in the next few months. Take a look at your portfolio. Ensure you’re not overexposed to speculative stocks, or that any one position isn’t too big should it go against you. If it is, derisk!

Have a stop-loss in mind so you know where to cut your losses if prices move against you.

Soon after I finished that update, I had a scheduled video interview with Peter ‘Chewie’ Bakker. We discussed the fact that the algo is 100% in cash at the moment, and that it is detecting high levels of stress in the market.

That is, market makers in the US are paying significant premiums to hedge their risk. We discussed the VIX, and the fact that a big spike in the VIX only resulted in a small drawdown in the S&P 500.

To give you a sense of how unusual that is, check this tweet out from @MacroCharts:


Big Increase in the VIX (volatility)

Source: @MacroCharts

[Click to open in a new window]

 

In other words, a very big increase in the VIX (volatility) resulted in only a very small fall in the S&P 500. It wasn’t just unusual, it was unprecedented.

Anyway, the gist of the conversation with Chewie is that risk is very much mispriced right now. Remember, just because you accept risk doesn’t mean you get rewarded for it. Sometimes you get a smack in the face.

He showed a chart of the VIX Index term structure, which suggests the next few months will not reward risk takers.

While we don’t know the future, the key takeaway is that the probability of a decent correction is increasing. That doesn’t mean we’ll get one. But if the market continues higher from here, it means underlying risks and stresses will probably only increase.

The whole point of a correction is to flush out the excesses and imbalances that occur in a strong market. They’re scary, but necessary.

Finally, yesterday afternoon, Murray Dawes’ Pivot Trader update came through.

After a shaky start to the week, we have seen a dramatic bounce, with the ASX 200 up over 200 points from the lows reached on Monday morning.

Now that we have the weekly sell pivot in place there is a higher probability that the buying will meet stiff resistance at some point.

The ASX 200 Index is trading at 6,650 currently and I reckon around 6,700–6,740 will be tough to get through in the short term.

The monthly trend is still up so I’m not making any big statements about market direction. I’m just saying that the weekly charts are saying that there is a higher than normal risk that this buying is a bull trap rather than a buying opportunity.

When I make any statements about the markets in general you shouldn’t think that those views are set in concrete. They will change as new data arrives. I’m not beholden to my view and am happy to change as the charts change.

I am just trusting the trading model and interpreting market action based on that.

The ASX is right in the sell zone of the whole wave down in the crash. So, there is a higher probability that a reversal from this zone could have targets towards the point of control of the wave at 5,800.

That would be a 12% correction which is a fairly decent fall.

I’m not saying that we are about to see that happen. Just that the weekly sell pivot in that zone is enough for me to take a bit of money off the table and tread carefully until things resolve.

As I said, we haven’t discussed our views on the markets this week. It’s not something we do. We don’t have a ‘house view’ and I don’t want us to all think the same.

But when a bunch of experienced people all see a poor risk/reward setup, I think it’s worth alerting you to it. Yes it’s opinion, and yes we could be wrong. But the fact that Chewie’s algo is seeing stress build too, which is not an opinion but based on real data, is an added confirmation.

One other point to note here: None of us are talking about a market crash. We’re simply saying that the odds of a decent pullback are increasing, and to keep that in mind when managing your portfolio.

If you’re a long-term investor you probably don’t need to do too much.

One thing I do tell my readers to do is build up an allocation of ‘tactical cash’. That is, have some firepower to deploy should a correction unfold. So instead of panicking and wondering what to sell, you’ll be on the lookout for something to buy.

Regards,

Greg Canavan Signature

Greg Canavan,
Editor, The Rum Rebellion

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Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

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