There are many ways to evaluate the market in attempts to better understand the underlying dynamics of what’s taking place in the day-to-day and week-to-week price action. It can be a slippery slope attempting to explain why trend change, but I believe this exercise can be useful in understanding market risks and the potential resulting price action that can follow.
When conducting my research, I use a ‘top down’ approach, meaning I begin with the broad market and make my way through the sectors, industries, and individual stocks. Understanding the macro trading environment and the most prevalent risks associated with it allows me to properly layout my risk management discipline. Below I give several examples of tools that can be used to evaluate the two types of trend changing catalysts, these are by no means a definitive list! As you would not use just two or three colors to paint a landscape, we are not limited to just two or three types of data or indicators when conducting our technical analysis of the market.
I believe the catalyst for short- to intermediate-changes in trend can be broken up into two baskets. These groupings are purposely broad and are not hard-and-fast laws handed down by Wall Street ancestors nor is one always present in the market. Most of the time we aren’t in either basket but understanding what each of them are and how they can be understood is an import part of my ‘top down’ process as the historical market reactions are distinct to each. They are simply frameworks for evaluating the types of market environments we may find ourselves, based on the inner-workings of various sets of data. You’ll notice I am leaving out headline-driven catalysts. Headlines and news stories that move the market aren’t something we can forecast or anticipate, which is why I chose to focus on what I can measure and analyze instead.
Structural Market Risks
The first group of trend-changing catalysts is structural. This group is made up of breadth measurements, which provide analysts the opportunity to evaluate the level of participation by individual stocks, sectors, industries, etc. At the end of the day, the stock market truly is a market of individual stocks and what those pieces are doing dictates the long-term trend of the whole. When we have good breadth (growing participation) of stocks moving in the same direction as the overall market then its often safe to assume that trend will continue. This goes for both rising and declining trends.
When the individual components of the market begin to breakdown, the structure becomes threatened. The timeframe for the resulting impact can varying greatly, it’s like playing a game of Jenga. As more pieces are pulled from the base and placed on top, the tower grows but becomes more and more unstable. You can’t know for sure which piece pulled will result in it coming crashing back down to earth, but a casual observer can recognize the instability being forced upon the tower. With each decline in breadth causing a wider spread or divergence relative to the market, the trend becomes threatened just as the Jenga tower becomes less stable.
When the structure becomes vulnerable the resulting change in trend can be severe. Thankfully, this type of trend-changing catalyst is not presented to the market very often. We saw it most recently in the fourth quarter of 2018, which resulted in a 20% decline in U.S. equities. Last summer the degree of participation in the rising trend of the S&P 500 was buoyed by just a handful of stocks, dubbed FAANG. Many market pundits justified the over-reliance on the FAANG stocks pointing to periods in the 1990s where breadth was narrow, and the market trekked higher. Others pointed to the rising Advance-Decline Line as reasoning to why breadth still was bullish. I tried to stymie this idea by pointing to the math behind the A-D Line can mask underlying market weakness in a blog post last August. Unfortunately, the Jenga tower could only sacrifice so many pieces from its foundation in the name of higher prices before price began to respond and the major indices moved lower. Thankfully the resulting decline was contained to recoverable levels of loss. 2007 was a different story. Looking back the decline in breadth is crystal clear (as hindsight often is), but as the Jenga pieces came tumbling down, the damage done was ‘game over’ for many investors.
Sentiment Risks
The second group of trend-changing catalyst is sentiment-based. As long as humans are manning the stations and firing off most of the buy and sell orders, boom and bust sentiment will be a market symptom we can’t shake. There are many different pieces of data that attempt to shine a light on the sentiment of the investing public, what you chose to use is totally up to you.
Volatility
While I often look at many sources of sentiment tools, my preference is for the data derived directly the market – and the Volatility Index does just that. The function of the VIX is simply to communicate the market’s expectation of future volatility over the next 30 days. This figure is often viewed as a “fear gauge” as market volatility is often associated to the downside. With that, when the VIX becomes low, it’s telling us the options market for the S&P 500 no longer has a high expectation that there will be large swings in equity prices in the near future. However, as I wrote earlier this week, the fact that the VIX is low alone doesn’t signify the likelihood that it will spike higher.
One method of using volatility to gauge market sentiment is comparing it to volatility further out on the futures curve. For instance, we can compare front month or spot volatility to 3-month volatility. In a normal market environment volatility futures contracts 3-months out will trade at a premium to the current contract as the curve is upward sloping. The range of that premium can vary widely, and that spread can lift the veil on investor sentiment. When the spread is high then the market is either over-pricing long-dated volatility or under-pricing short-dated volatility. I think more often than not it’s the latter more than the former as traders grow overly complacent in their volatility expectations. However, this is just one simplified method of using volatility as a sentiment gauge, there’s many other ways to view this data which I do regularly in my Thrasher Analytics letter.
Other Sentiment Tools
Another piece of sentiment data is produced daily called The Daily Sentiment Index, which gives a percent bullish reading for nearly all the futures markets including commodities, Treasury’s, equity indices, and volatility. When these figures get excessively high or at extreme lows, then we are often in periods of time where investor sentiment has grown out-of-balance for that specific market. There’s also several market survey’s such as the AAII, NAAIM, Investor Intelligence, etc. that provide a window into the sentiment of investors. Or we can take a look at compilations of market-based data, such as the CNN Fear & Greed index which looks at relative performance of stocks vs. bonds, put/call ratios, momentum, volatility, and bonds to quantify trader sentiment.
From my view, the market’s reacts to sentiment-related excess – when the structure of the market still appears intact – the decline is much faster, and the drawdown is less severe. We’ve seen the release value of excessive sentiment move the markets lower often from five to ten percent. A recent example was January 2018 when the S&P 500 DSI score got north of 90% and the spread between the 1-month and 3-month volatility breached 3 points. The S&P eventually declined by 10% over just a few trading days, bounced, tested the initial low and then moved back to new highs. The whole ordeal was over within a matter of weeks and many retail investors who were simply looking at their monthly IRA statements might not have even noticed it!
Not Mutually Exclusive
The two groups aren’t mutually exclusive, there’s periods of time where both
structural weakness and excessively bullish sentiment can develop at the same
time. You could argue that 2011 was an example of this – S&P 500 sentiment
got above 90% and the number of stocks trading above their 50-day Moving
Average had been on the decline – stocks then corrected by a little over 20%.
What About Today?
If you had asked me two weeks ago, I would have said the major risk to the market at that time was structural. Initially there were several developing divergences in breadth indicators with a marginal number of stocks rising and hitting fresh highs along with the major index. That problem resolved itself with an expansion in breadth but along with it has now come rising sentiment concerns. I believe the market is now structurally on better footing than it had been in Q4 of last year, but the volatility curve has steeped quite a bit, sentiment scores are north of 80% for the S&P 500, Nasdaq 100, and Nikkei Index and the CNN Fear & Greed Index recently hit a new two-year high. With that, I think the biggest risk to the market today is sentiment-focused. Excessive sentiment risk can be digested through time, meaning the market trades sideways for a period or through a marginal correction in price as weak hands get shaken out and stocks test support levels.
The Key Takeaway
What’s important is understanding when and where the risk is within the market, evaluating the structure of stocks – have too many Jenga pieces been pulled out? Check the sentiment data – has the proverbial teeter-totter gotten too weighted to one side, requiring a brief ‘reset’? By having a better idea of which (if either) risk has developed and what triggers are important to your process for trading or managing a portfolio, importantly, your time frame for your investments, a risk management process can be properly built and responded to. Through this exercise of evaluating each type of risk independent and then collectively, I’m able to quantify the data I believe to be important and properly adjust my market bias and risk tolerance.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.
