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Stock Market Fear and SPX Toppings

Stock-Markets / Financial Crash May 04, 2012 - 12:34 PM GMT

By: Zeal_LLC

Stock-Markets

Best Financial Markets Analysis ArticleWith the US stock markets surging nearly a third higher in just 6 months, the odds are rising for a major topping.  As the best times to sell high, recognizing these events in real-time is very important for traders.  But it is a big challenge due to the gradual way toppings unfold.  An indicator that can really help is the famous implied-volatility fear gauges.  They tend to exhibit unique and identifiable behaviors at toppings.


This is counterintuitive at first, as the dangerous emotion of fear is rightfully associated with bottomings.  Traders get scared when the markets sell off sharply, and fear flares as new interim lows are hit.  Toppings, on the other hand, are exciting times laden with complacency, greed, and sometimes euphoria.  These equally dangerous emotions are at the far opposite end of the markets’ sentiment spectrum from fear.

And this is the key, greed and fear are mutually exclusive.  I’ve always thought of popular market psychology swinging back and forth between these two extremes like a great pendulum.  If markets have just plunged to new lows, the resulting overpowering fear vanquishes all other emotions.  And if markets have just climbed to new highs, fear is nowhere to be found.  Greed can only exist in the absence of fear.

Thus the same implied-volatility fear gauges that so precisely flag major bottomings can also be used to discern toppings.  High readings in them denote extreme fear, only seen at bottomings.  And low readings reveal the lack of fear, which only happens when that sentiment pendulum swings back to extreme greed.  So while there is no greed equivalent of “fear indexes”, they effectively reveal the whole fear-greed continuum.

Of course the most popular fear index is the VIX, which uses complex formulas to crunch S&P 500 (SPX) options prices expiring over the next 30 calendar days.  Basically the higher options prices go, the more near-term volatility traders expect.  And volatility spikes dramatically during episodes of fear, while collapsing when greed reigns.  So a high VIX effectively indicates fear, and a low VIX the absence of it.

Shouldn’t volatility be equally likely in greedy toppings?  Maybe in theory, but definitely not in practice.  Greed and fear are very asymmetric in their immediacy.  Greed is a slow motivator, few traders are in a hurry to buy high after a strong rally.  But fear shocks traders into immediate action, prices spiraling down to new lows spark an intense psychological need to sell instantly.  So high volatility is truly a fear thing.

While the VIX is fine, I prefer the original old-school VIX now known as the VXO.  This only looked at S&P 100 options, the top 20% of SPX companies.  And it only looked at at-the-money options.  During sharp selloffs, the biggest and most-liquid stocks are the first and most heavily sold.  Only they have the necessary liquidity to absorb big selling.  And at-the-money options are quicker to respond with bigger moves than out-of-the-money ones.  So the classic VIX, today’s VXO, remains a superior fear gauge.

As this first chart shows, the VXO indeed behaves in a certain unique way when major toppings are unfolding.  The VXO S&P 100 implied-volatility index is shown in red with the SPX superimposed in blue.  The time horizon encompasses our current cyclical stock bull that was born in March 2009.  Each time a major upleg tops before a major correction, the VXO’s technical behavior is quite similar.

This strong bull market has witnessed two previous major toppings, after each of its first two major uplegs.  They occurred in April 2010 and April 2011, which is another seasonal reason why many traders are looking for this bull’s third major upleg to top in spring 2012.  By comparing the recent VXO and SPX action with that seen in those earlier indisputable toppings, we can better forecast the next major one.

First note that the earlier toppings were gradual, the SPX slowly climbing to new highs before plunging sharply in steep corrections.  This again highlights the inherent asymmetry in greed and fear, with the former building slowly while the latter erupts quickly.  Therefore the VXO behavior marking these toppings is a lot less sharp and defined than the isolated massive fear spikes seen at major bottomings.

And just like the VXO has an effective ceiling of 50 during times of extreme fear (excluding ultra-rare panics and crashes), it has a floor during times of extreme complacency and greed.  And that is in the lower teens.  The VXO rarely goes below 11 or 12, even after a multi-year cyclical bull has driven serious fear spikes far from traders’ memory.  So that is effectively the fear floor, or therefore the greed ceiling.

While the VXO rockets up to bounce off its ceiling during bottomings after sharp corrections, its floor approaches in toppings are vastly more gradual.  The VXO’s rate of decline gradually slows, creating the fear decay curves shown above associated with toppings.  For lack of a better term, I call this asymptotic flattening.  In math an asymptotic curve keeps approaching a line (the asymptote), but never quite hits it.

As fear decays and therefore greed grows, the VXO continues to bleed off at an ever-slowing rate as it approaches its effective floor.  So the very existence of these asymptotic curves ushering the VXO into the low teens is a major topping flag.  While they don’t offer wonderfully precise sell signals at toppings like the sharp spikes’ buy signals at bottomings, this pattern is still fairly easy to identify in real-time.

Second, these fear decay curves are usually interrupted by a sharp VXO spike higher in the couple months right before the ultimate SPX topping.  These spikes correspond to pullbacks, relatively minor retreats in the stock markets that are far from correction magnitude (over 10%).  Within the gradual stock-market topping process, there is almost always one sharp pullback just before the final ascent.

Pullbacks are essential in toppings.  They rebalance sentiment, ensuring that greed doesn’t climax prematurely before all potential near-term buyers have been sucked in.  Pullbacks also help convince skeptics that they should indeed buy so late in a major upleg.  When the initial sharp selling in a pullback doesn’t snowball into a full-blown correction, plenty of traders still hiding on the sidelines are persuaded to buy.

After these late-upleg pullback-driven VXO spikes, this fear gauge quickly collapses back down into its original decay curve.  The lower the VXO gets in an absolute sense, the longer it has been near those levels, and the more horizontal it trends, the higher the odds a major topping is happening or imminent.  Such low volatility levels imply greed and complacency has reached unsustainable extremes.

So unlike the short-lived highs the VXO sees at major bottomings, its famous fear spikes, major toppings are marked by long-lived lows.  This is critical to understand, as the implied-volatility fear gauges are often misused by traders when trying to identify toppings.  I often hear analysts say because the VIX hit 15, or 14, or whatever, that a major selloff is imminent.  But that isn’t necessarily true, the decay curves are gradual.

Back to the chart above, note how long it took for the VXO to asymptotically flatten towards its effective floor as this bull’s first two major uplegs started topping.  We are talking about several months or more, a very gradual process, after various new VXO lows for an upleg are witnessed.  Compare this precedent to the VXO’s decay curve today, and it is readily apparent our latest VXO flattening still looks premature.

While the VXO has fallen into the low teens relatively rapidly so far this year, it sure hasn’t spent much time down there yet.  So the horizontal component of the VXO decay curve really hasn’t been seen.  Does this mean the SPX can’t have already topped or won’t this week?  Of course not, but it certainly lowers the odds.  Today’s VXO decay curve is still due to extend horizontal for another month or two.

We did get a notable pullback spike in the recent early-April stock retreat, which will probably prove to be the necessary one before the topping.  Even though it was much smaller than in the first two uplegs’ toppings, this is to be expected.  The older a cyclical bull gets, the more general background fear fades away.  So the VXO lows, and lesser spikes, tend to gradually decrease as a bull market matures.

Based on its bull-to-date precedent, the recent SPX and VXO action make it look like the gradual topping process for this bull’s third great upleg has indeed started.  But given how short-lived the late-March VXO lows were, and how the flattening of the VXO decay curve hasn’t gone horizontal yet, we probably haven’t seen the ultimate top.  Nevertheless, traders should be very cautious here.

This next chart certainly isn’t one of our prettiest, sorry.  I wanted to examine the VXO decay curves leading into SPX toppings in more detail, so the VXO axis has been exploded to a narrow bottoming range between 12 and 21.  And for each major topping, I looked at the periods of time between when the VXO first crosses major milestones in that particular upleg to the SPX’s ultimate peak in that upleg.

I’m interested in how long the SPX topping tends to occur after a particular VXO low is first reached in that upleg, and the percentage of trading days between that initial VXO low and the topping that are under that VXO milestone.  So in this bull’s first major upleg, the VXO first went under 20 4.9 months before the SPX ultimately peaked in April 2010.  And after that first sub-20 VXO close, 66% of the trading days between it and the upleg top had VXO closes under 20.

For each upleg this data is noted, starting with the VXO first closing under 20 and ending with it first closing under 14.  This admittedly kludgy methodology gives us a hard empirical baseline from which to measure the visual VXO decay curves leading into toppings.  And it helps us compare this latest VXO flattening with the ones signaling the ends of this bull’s earlier major uplegs, ideal sell-high times.

The first important takeaway is to realize that the VXO falling below a certain round level on close for the first time is definitely not a topping signal as traders like to argue.  Regardless of which VXO milestone is being discussed, the actual SPX tops occur weeks to months after a VXO low is first seen.  So unlike major SPX bottomings with huge fear spikes hitting important absolute levels, toppings are much fuzzier.

Since the topping in our current third major upleg is still unknown, I took the metrics out to today rather than assuming the recent early-April high was the topping.  So as of this week it’s been 3.7 months since the VXO first closed under 20, and 98% of the trading days since then have seen sub-20 VXO closes.  Contrasting these metrics with previous uplegs’ is interesting, buttressing the topping-coming-but-not-here-yet thesis.

The first upleg didn’t top until 4.9 months after the VXO first closed under 20, and the second until a whopping 7.3m later.  So by this measure today’s 3.7m span to present is definitely on the light side.  The same applies to the first sub-19 VXO close and sub-18 VXO close as you can see above.  This fear gauge hasn’t yet spent enough time under these milestone levels recently based on bull-to-date precedent.

The comparison gets murkier at the VXO sub-17, sub-16, and sub-15 levels.  Our current upleg has seen the VXO spend considerably more time under these milestones than it did in this bull’s first upleg, but considerably less than the second.  So is there a particular upleg behavior it is more logical to err towards?  The first one’s topping was sharper and faster, while the second one’s was prolonged and more gradual.

Due to the way sentiment unfolds in an ongoing bull, our current upleg’s topping is more likely to be of the gradual persuasion.  Early in a new bull just after a brutal cyclical bear, fear remains quite high as traders are frightened the bear will return.  So there is much skepticism on whether or not a new bull is even unfolding (as opposed to a bear-market-rally trap).  Thus selling tends to cascade more quickly at any sign of weakness.

But as the months and years of cyclical-bull rallying mount up, naturally the background level of fear steadily fades.  So on average as bulls mature, fears of a big selloff (even a correction) wane dramatically.  And with fewer traders motivated to sell rapidly, toppings become even more drawn out.  Thus probabilities favor major topping processes lengthening as a bull market slowly matures.

And with our current cyclical bull being born way back in March 2009, we are now nearly 38 months into it!  The average lifespan of previous mid-secular-bear cyclical bulls in modern history is just under 35 months each.  So our current cyclical bull is definitely getting long in the tooth, drawing out toppings and pushing the VXO to lower floor levels than we’d have any chance of seeing early in a bull.

By these later gradual-topping standards, we haven’t yet seen enough time between various milestone VXO lows first being hit and today.  And this comparison looks even more lopsided if the month between the latest SPX interim high and now is subtracted out.  Thus in VXO-decay-curve terms, it sure looks like the SPX hasn’t topped yet but is probably on course to sometime in the next couple months or so.

Naturally we are closely watching this unfolding topping process at Zeal.  It is very important.  While the best case is this coming topping merely precedes another mid-bull correction, there is a good chance it may actually mark the end of this cyclical bull.  And if that proves true, we are in for another brutal cyclical bear that will probably batter the SPX back down near its secular support at 750 over a couple of years!

While cyclical bears can indeed be very profitably traded on both the short side and long (sharp bear-market rallies), the necessary trading strategy is radically different from what works in cyclical bulls.  If you haven’t traded through a cyclical bear before, or even worse don’t know one is upon you until too late, you are probably going to get slaughtered.  Thankfully we can help you navigate whatever is coming.

We publish acclaimed weekly and monthly subscription newsletters loved by speculators and investors worldwide.  In them I draw on our vast experience, knowledge, wisdom, and ongoing research to explain what the markets are doing, why, where they are likely heading, and how to trade them with specific stock trades as opportunities arise.  Subscribe today!  We also publish comprehensive fundamental reports on our favorite stocks in promising sectors.  The latest are on the wildly-oversold gold juniors.  Buy yours!

The bottom line is the implied-volatility fear indexes can also be used to identify major toppings.  While they don’t measure greed and complacency, the absence of fear is necessary for these topping emotions.  Following big stock-market uplegs, fear gradually decays until the fear indexes start flattening towards horizontal.  After some months of fear slowly evaporating, the stock markets finally carve a major top.

While the latest fear-index reads suggest the topping process has already started today, we are still a month or two out from the ultimate stock-market highs based on bull-to-date precedent.  This is actually very fortuitous, as it gives speculators plenty of time to layer out of positions put on for this upleg.  And cash is king after any topping, whether it leads to a mid-bull correction or a new bear market.

Adam Hamilton, CPA

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

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

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

Copyright 2000 - 2012 Zeal Research ( www.ZealLLC.com )

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