What the VIX Says About Stocks Today

The market’s crystal ball is giving us a warning sign.  Watching the price action in Volatility Index (VIX) options is like staring into a crystal ball for the stock market.

The Volatility Index is a measurement of fear in the marketplace. When the VIX is high and rising, investors are scared and traders are bearish. A low and declining VIX indicates strong bullish sentiment and complacency among traders.

Fear GuageThe VIX is a good contrary indicator, and it does help warn investors when the market is at extreme levels. Today the VIX is a historically low levels. Some of the best forward looking clues about future stock market performance come from VIX options.

VIX options are European-style contracts – meaning they can only be exercised on option-expiration day. This eliminates any possible “arbitrage” effect (the act of buying an option, exercising it immediately, then selling the underlying security for a profit). So VIX options will often trade at a discount to their intrinsic value.

For example, on July 11, the Volatility Index closed at 12.08. But the VIX July 14 puts – which are intrinsically worth $1.92 – were trading at only $1.60. That’s a $0.32 discount to intrinsic value…
If it were a regular American-style stock option, you could buy the put, exercise it, and liquidate the position, picking up $32 for every contract you traded. The European-style feature prevents that from happening – because you can only exercise this contract on July’s expiration day.

This makes VIX options difficult to trade. It is remarkably difficult to profit by trading options on the VIX.

But we can still benefit from VIX options… they provide clues about where traders expect the VIX to be on option-expiration day.

The current VIX option prices tell us that traders expect the VIX index to move higher in the months ahead. The VIX July 12 calls closed last week at $0.75, while the July 12 puts were only $0.19. In other words, option traders were willing to pay three times more to bet on the VIX moving higher than on it moving lower.

The difference is even more significant going out to October. The VIX October 12 calls are trading for $3, while the October 12 puts are just $0.40. So options traders are willing to pay seven times more to bet on the VIX moving higher than on it moving lower by the October expiration day.

VIX option traders clearly expect volatility to move higher over the next few months. And rising volatility usually translates into falling stock prices. With the market trading at all-time highs, it’s time to be cautious on stocks right now.

Unprecedented Bear Market Formation

Inside Look: Check out this Unprecedented Bear Market Formation Since 2000
Think the current conditions in the stock market are normal? Think again. Here are 3 characteristics you should expect to see in wave b.

By Elliott Wave International

Editor’s Note: Below you will find a sneak peek from the just-published issue of Robert Prechter’s Theorist. It provides you an opportunity to see some of the research, analysis and forecasts that Elliott Wave International’s subscribers are enjoying inside their latest issue.

Figure 4 (below) is a diagram from Chapter 2 of Elliott Wave Principle. It displays a typical progression of prices and psychology in a bear market. We can apply this picture to the stock market since 2000. The real-life pattern is a bit more complex than this picture, because wave a itself was a flat correction, which ended in 2009. The dashed line in Figure 4 represents what the market has been doing since then: rallying to a new high in a b-wave. The entire formation has been tracing out an “expanded flat” correction (see text, p.47) of Supercycle degree.

bear market

Per Figure 4, among the characteristics we should expect to see in wave b are: “Technically weak,” “Aggressive euphoria and denial” and “Fundamentals weaken subtly.” The volume contraction in the stock market has now lasted over five years, which is extreme technical weakness, albeit only in that indicator. The 30+ charts we have shown of market sentiment reveal historically high levels of optimism regarding stocks. No doubt bulls would dismiss the idea that investors today exhibit “aggressive euphoria and denial.” But look at Figure 5.

bear market

It shows that the yield on junk bonds has just reached its lowest level ever. Junk bonds did not even exist prior to 1989. In 2009, investors were deathly afraid of them. Now they cannot get enough of them. They are thinking only about yield; they are ignoring risk to principal. That’s denial. Finally, fundamentals have not just weakened a bit but rather are awful. The economy is flat, the amount of debt is at a record high, and as shown in the June issue of The Elliott Wave Financial Forecast the quality of debt is at a record low.

There has never been an expanded flat pattern as large as Supercycle degree in recorded stock market history, going back 300 years. It’s a first. So, we are getting commensurate expressions of stupendous optimism, which will prove worthy of the record books. People think today’s market conditions are normal, because a benign present is always considered normal. But it’s not normal. It’s unprecedented.

Would you like to see the rest of the issue for free? For more details, the complete wave count, and EWI’s forecast for how they believe it will all play out, continue reading Prechter’s 10-page June Theorist now, completely risk-free.
Learn more here.


Stock Market’s Shaky Foundation

According to the stock markets in the U.S. and in Europe, the world’s economy is not just in good shape, but is in the best shape it’s ever been.

Stock Market's Shaky FoundationThe S&P 500,  the Dow and Nasdaq continue to surge upward. The S&P 500 is now 20 percent above the peak it hit in 2007, a moment everybody now recognizes was heavily overvalued.

An 20 percent gain above the prior all time high is an enormous and unusual event. Surely, you are thinking, there must be an equally compelling story and loads of fundamental data to support such a bull market?

There really isn’t.

Not a lot has changed between the prior 2007 peak and today. From a fundamental standpoint, not much at all. Per capita income is only up 8.1 percent between now and then, and yet the equity markets are rallying like the biggest income boom in all of history has occurred.

Worse, the per capita income data is obscuring the fact that what little income gains have been recorded went almost entirely to the top 10 percent of the population. So there’s no broad prospering middle class to drive an economic expansion of the sort that stocks seem to be pricing in.

The main narrative today has nothing to do with anything fundamental. Rather, it centers on the idea that as long as the central banks of the west and Japan continue to print, everything financial will just continue to go up in price while — somehow — price inflation will remain tame.

Our view here at Prepare and Prosper is that this narrative is wrong in every respect; except, perhaps, for those engaging in short term speculation that ignores both fundamentals and history.

In the immediate term, stock prices gyrate based on various assumptions that are often completely disconnected from reality.

But over the medium and longer terms, fundamentals drive prices; as it is ultimately corporate income and ultimately dividends that determine the value we ascribe to equities, and it’s the prospect of future earnings growth that drive the price multiple.

The Big Picture

Over the long haul equities are nothing more than a means of sharing the wealth that companies create, which itself is a product of the extraction and processing of real things from the real world.

Everything we think we know about the ‘fair value’ of equities was developed over a period of time when the future could always be counted upon to expand exponentially.

You know, sayings like “Over the long haul equities return 10 percent”.

Such a statement can only be true in an exponentially expanding world where exponentially more things are being extracted from the real world as time goes on.  In a world where there is only so much ‘stuff,’ it’s not possible for said ‘stuff’ to always be present in expansive and expanding quantities.

A huge enabler of the economic expansion of the past century has been oil. Without a doubt, petroleum is the master resource for a global economy. And it is no longer cheap.  The reason why it is no longer cheap, and never will be again, is a larger story than we have time for here, but recent data should suffice to show that global oil has averaged more than $100 per barrel for more than three years. That’s 4x higher than the 1987-2004 average of $23 per barrel

The anemic economic growth in the OECD countries, with their horrible job creation statistics and generally tepid recoveries (at best), is the very predictable result of what you get when oil becomes expensive.

If you hold the view, as we do at Prepare and Prosper, that the future economy cannot possibly grow at the same rates as it did in the past, then equities are in for a serious correction at some point.

That day may still be far in the future. But there must always be an eventual reckoning between the number of claims on the world’s wealth world and the actual wealth itself.

Further increasing the risk for equities is the fact that, as claims on wealth, they are the least senior of the lot.  The holders of bonds and preferred shares come first.  So when we wander over to that other, and much larger, corner of the financial universe where debt resides and note that all forms of debt, but especially corporate debt, have continued to grow exponentially both before and after the great 2008 credit crisis, we see that equities are whistling past this part of the story too.

A huge proportion of all the new corporate debt taken on since that little hiccup in 2009 has been used to buy back shares and thereby goose (through accounting, not by value creation) the earnings per share numbers so widely reported by the financial press.

Eventually, though, all that corporate debt will have to be paid back, and that activity will drain future cash flows and earnings. Again, steadily rising – nay, exponentially rising – levels of corporate debt are a massive collective bet that the future will be exponentially larger than the present.

The only narrative I can imagine that can accommodate a long-term decline of per capita resources coupled to steadily worsening net energy from petroleum, AND simultaneously support the continued exponential expansion of claims against those resources, is one that steadily transfers this wealth into fewer and fewer hands.

After all, if relatively few people end up owning most of the remaining wealth, does it really matter to them that there’s less of it to go around on a per person basis?  No, not if they have plenty for themselves.

As the recent travails in Ukraine have showed us, there’s only so far that such a deranged, kleptocratic view can go before it breaks down.

Alternatively, and far more likely, there’s no actual rational narrative of any sort in play right now — and so the center mass of the investing world is simply operating off of untested and unexamined beliefs that mainly rest on the notion that a prompt and perpetual return to exponential growth is what the future holds.

Again, we see this as dangerously myopic. But sadly, this view is not only rampant on Wall Street, but it’s also prevalent with our government as well as endowments, pensions, and insurance pools — entities with long-term fiduciary responsibilities that really aught to be asking themselves some hard questions these days.

Conclusion

In summary, over the long haul — by which we mean the next decade — current equity prices are making a colossal bet that exponential economic growth, which itself is linked to cheap oil, is going to quickly resume and persist long into the future. Are you comfortable making that bet? we’re not.

Of course there are a lot of variables in play here; but one could do worse than to simplify one’s economic prediction down to this: Until and unless the global supply of oil gets a heck of a lot cheaper, anemic economic growth will persist and therefore the holders of expensive financial assets that are priced for perfection will be badly disappointed.

The Approaching Inevitable Market Reversal

Though we’re constantly reassured by financial pundits and the Federal Reserve that the stock market is not a bubble and that valuations are fair, there is substantial evidence that suggests the contrary.

The market is dangerously stretched in terms of valuation and sentiment, and it does not accurately reflect fundamentals such as earnings and sales growth.

read more

The QE Box

The Federal Reserve has investors trapped in the QE box. Your local bank pays nothing on deposits. Government bonds aren’t much better. The clear message is “no risk, no return”. The economy lacks aggregate demand, according to the Keynesians. Investors can fix that problem:

  1. People buy stocks;
  2. Stocks go up in price;
  3. People feel richer;
  4. They go shopping and jobs are created.

Easy, right?

Not so much.

The Fed’s largess has sloshed into the canyons of Wall Street, Iowa’s fertile farmland, crypto-currencies, and Miami’s condo market. Yet, main street still suffers.

Main Street’s funk will keep the Fed on the job forever, we’re told. With the government having the market’s back, will interest rates ever go up? Will stock prices ever go down?

Wall Street won’t fight the Fed. But remember, while Janet Yellen, the Fed chairwoman, wants you to risk your retirement to carry out her central-planning experiment, she is just a government employee working toward a pension. A risk-taking, farsighted entrepreneur she is not. Without the fancy PhD behind her name, Janet Yellen might be working at the DMV or delivering your mail.

Robert Prechter and the folks at Elliott Wave International don’t bow on the steps of the Eccles Building.

The PhDs at the Fed can plug figures into their models, print money, and fix interest rates all they want. EWI’s analysts know that markets reflect the public’s mood. The central bank isn’t “pushing on a string,” as Keynesians would say, it’s pushing against public sentiment in vain. The market will ultimately reflect this sentiment.

Changes in mass psychology occur in measurable patterns identified by Ralph Nelson Elliott in the 1930s. Robert Prechter has used the Elliott Wave Theory to not only predict financial markets but election results and other events in society. For instance, in 1995 Prechter wrote that social mood governed society’s tolerance for recreational drugs.

As Prohibition was launched at the beginning of a bull market in 1920 and repealed at the depths of the Depression in 1933, the current War on Drugs began in 1982 at the origins of a bull market and will be abandoned at the bottom of the next depression. With multiple states legalizing marijuana, that time grows near.

If you’ve never studied the work of the Elliott Wave Theorist, below is your chance. In a word, the work of Prechter and his staff is compelling.

What follows are five charts and commentary from a recent Elliott Wave Theorist. The charts should alarm anyone fully invested in stocks.

Elliott Wave’s View from the Top

By Robert Prechter, Elliott Wave International

EW - The bear market started in 2000

The stock market top has eluded us. Prices have repeatedly passed what we thought were terminal junctures. But the charts just keep getting more bearish.

The top graph in Figure 7 shows the S&P that everyone is watching. New bull market, right? Wrong. The middle graph shows the real S&P, which has been in a bear market since the first quarter of 2000. The Fed’s liquidity has re-fattened the banks, and bankers in turn are lending the new money to wealthy institutional speculators, who use it as collateral to buy stocks on ten to thirty times leverage. This is not a bull market but a hyped-up bear market rally.

As Elliott Wave Principle […] said 35 years ago, “If the analyst can easily say to himself, ‘There is something wrong with this market,’ chances are it’s a B wave [a bear market rally].” There is something not just wrong but sick about a market that is making new all-time highs for seven months on the subterfuge of a purposely debased measuring unit and the central bank’s financing of speculators with value stolen from savers.

The huge difference between the top two lines on Figure 7 highlights how remarkable it is that nominal prices for gold, silver, and commodities are down 30%-60% from their highs. In real terms, they have fallen even further.

The lower graph on the chart confirms our interpretation that the post-2000 rallies are bear-market rallies. Main Street knows that the recovery is phony, and its assessments of the economy are in lock-step with the real S&P, not the phony one. The depression is ongoing, and counterfeiting money can’t stop it.

EW - Most stocks below their 2007 high

Big-cap institutional issues are pushing up the popular averages, but the NYSE Index—a broad measure comprising 1,860 stocks—hasn’t even passed its 2007 high in nominal terms, much less in real terms. Per Figure 8, the broad list of stocks is still in a bear market no matter how you look at it.

EW - The public plunges into stocks

This year, Elliott Wave Theorist and Elliott Wave Financial Forecast have showed two dozen charts of sentiment indicators at or near all-time expressions of optimism, and here are two more. Figure 9 shows that in the second-to-last week of October, the public poured more money into various US stock funds than at any time in at least seven years, which includes the 2007 stock market top.

EW - Cash-stock ratio

All this stock buying has created a lopsided investment ratio among fund sectors. As shown in Figure 10, the percentage of money in Rydex’s conservative money-market funds as opposed to speculative stock market funds is the lowest since 2001, which is just after the all-time high in the real value for stocks (shown in the middle graph of Figure 7).

EW - Optimism

So much for the public. What about professional advisors? Figure 11 shows that newsletter advisors polled by Investors Intelligence have just reached the lowest percentage of bears since 1987, over a quarter century ago! Under the Elliott wave model, that optimism made sense, because the market was in the third Primary wave of the bull market, the healthiest part of the rise. Still, those peak readings led to the second-biggest stock market crash of the 20th century.

The reading today, while not quite as extreme, is lower than that at the stock market peak of 2007, lower than at the peak of 2000, and just one-quarter of the percentage of bears recorded near major lows. In addition, the latest Daily Sentiment Index shows 90% bulls among S&P futures traders. Now observe on the upper graph that the S&P 500 Index is right at the upper line of a trend channel dating back to the 2009 low. Overall, then, we have near-record optimism at an all-time high, right at a point of trendline resistance.