Star Wars: The Last Jedi, through January 10th, has become the highest grossing movie released in 2017. The main character, Luke Skywalker uttered a line in the film that may be the perfect description of the overly-bullish sentiment we see in today’s U.S. Stock markets; “This isn’t going to go the way you think”.
It’s hard to argue against the idea that the markets are overdone. By nearly every measure, the 3 major U.S. indexes are overbought. The American Association of Individual Investors (AAII) has been performing a weekly market sentiment survey since 1987. Since then, AAII members have been answering the same simple question each week; where will the stock market be in next 6 months, higher or lower than where it is now.
As of the January 3rd, just fewer than 60% thought the market would be higher, up 7.1% from the previous week. 24.7% were neutral (in other words, thought the market would basically be right where it is now) which is down 2% from the previous week and 15.6% thought the market would be lower, down 5.1% from the previous week. That may not sound that bullish, but when you look at the historical averages (38.5% bullish, 31% neutral and 30.5% bearish) a different picture emerges. Currently, we have the highest bullish sentiment since December of 2010. According to the AAII, “There have only been 46 weeks with a similar or higher bullish sentiment reading recorded during the more than 30-year history of our survey. The S&P 500 index has a median six-month return of just 0.5% following those previous readings, up slightly more times than it has been down. Historically, the S&P 500 has realized below-average and below-median returns over the six- and 12-month periods following unusually high bullish sentiment readings and unusually low bearish sentiment readings.” But there’s more…
Fear Gauge Mastered the Force
As of January 18th, the S&P 500 has gone 393 days without a 5% correction. 395 days is the previous all-time record, putting the market only 3 days away from a new record as of January 18th. Through January 10th, the markets favorite momentum oscillator reached some astonishing heights in the Dow Jones Industrial Average. The weekly reading of the 14-period relative strength index (RSI) which measures the speed and change of price movement hit 88.25. Typically a market is considered overbought when the RSI moves above 70, but 88.25 is the highest momentum reading in over 100 years.
Additionally, the Volatility Index (VIX) commonly referred to by its nickname “the fear gauge” seems to have mastered the force as completely as Luke Skywalker because it shows no fear at all. 2017 was the year the VIX registered an all-time low of 8.56 and rose only as high as 17.28. That’s the lowest annual high of the past 20 years. It also marked the fourth consecutive year where the VIX fell, which last occurred during the stretch from January 2003 to December 2006. Before you run back and look at what stocks did after December of 2006, let me remind you that past performance is not indicative of futures results…having said that, the S&P rallied another 9.25% before a subsequent fall of 48.5% that began in October of 2017.
This brings us to our next similarity between the current equity market environment and the newest Star Wars installment. The opinions are very mixed. The critic’s score for The Last Jedi is much higher than the audience score. Most movie review sites mirror the very popular Rottentomatoes.com who gives the movie a 90% positive rating from 356 critic’s reviews while the audience score languishes around 49% with almost 173,000 user ratings tallied. Opinions are also very mixed on this equity market.
There’s legendary investor Bill Miller whose returns after fees at Legg Mason beat the S&P return for 15 consecutive years from 1991 through 2005. Mr. Miller is calling for a 30% “melt-up” in the S&P, potentially caused by a rise in long-term yields. He contends that if 10-year note yields rise to 3% and higher, loses will force money out of bond funds and into equities.
Hedge fund billionaire Jeffrey Gundlach, the founder of DoubleLine Funds is predicting a negative rate of return for the S&P 500 in 2018, which would be the first negative year after 9 consecutive positive years (another record). "It may go up 15% in the first part of the year, but I believe when it falls, it will wipe out the entire gain of the first part of the year and end with a negative sign in front of it,” he said during an investor webcast. Interestingly Mr. Gundlach thinks the catalyst might be….higher interest rates. The same reason Miller believes stocks will go up. Gundlach felt if the 10-year yield rises above 2.63%, it could start to hurt equities. He conceded that stocks may rise 15% before falling, which is basically the playbook from 2006, but again past performance, etc.
Despite the varied opinions, the key here is to know that overdone markets can stay overdone for long periods of time. What most people don’t know about the RSI, for example, is that “overbought” does not men ‘sell” while a market is in a strong uptrend. Quite the opposite, it likely means there is more upside to come. The trading strategy of picking tops has left more traders picking up the want ads than any other except maybe Martingale. When faced with a clearly overdone market and an unquenchable desire to pick a top, you may want to consider binary options and/or spreads. Nadex, the North American Derivatives Exchange, offers binary options and option spreads at a CFTC regulated exchange. Nadex products could be the best way to approach a volatile an overbought or oversold market because of the clearly defined risk when using these products.
According to research done by Bank of America, the largest buyers of equities currently are still hedge funds and companies buying back their own stock. Given that fact and the lower tax rate on repatriation of funds held abroad, our opinion is closer to Bill Miller’s than to Jeffrey Gundlach's. The rally should continue and records should continue to fall. The Fed stands poised to reverse course on their proposed 3 rate hikes for 2018 if anything harsh happens. This is not to say there won’t be any surprises in 2018. On the contrary, there will likely be some very soon, one of which being a 5% to 10% correction we see coming before the end of Q2. The catalyst…higher interest rates, but nothing as shocking as at the end of the Last Jedi when Luke Skywalker……
Nadex Risk Disclaimer
Trading on Nadex involves financial risk and may not be appropriate for all investors. The information presented here is for information and educational purposes only and should not be considered an offer or solicitation to buy or sell any financial instrument on Nadex or elsewhere. Any trading decisions that you make are solely your responsibility. Past performance is not necessarily indicative of future results. Nadex contracts are based on underlying asset classes including forex, stock index futures, commodity futures, cryptocurrencies, and economic events.
Trading can be volatile and investors risk losing their investment on any given transaction. However, the design of Nadex contracts ensures investors cannot lose more than the cost to enter the transaction. Nadex is subject to U.S. regulatory oversight by the CFTC.