If you’ve ever asked yourself the question, “How on earth could stocks possibly be moving higher right now when there are so many potential risks staring us straight in the face?” you have witnessed the Wall Street phenomenon known as “climbing the wall of worry.”
Wall Street climbs the wall of worry when the bullish momentum in the market is so strong that not even the potential for major market corrections is enough to scare traders away from buying more and more stock. We’ve witnessed this recently:
- Oil prices are plunging…No problem.
- The Russian economy is destabilizing…Meh.
- A rising U.S. dollar could hurt U.S. exports…Don’t give it a second thought.
- The Chinese economy is slowing down…Not to worry.
- Greece is destabilizing once again…Yawn, wake me when it’s over.
All the while, the S&P 500 has been climbing to new all-time highs.
So, how can we tell when Wall Street is climbing the wall of worry and not simply just climbing?
We like to watch the Volatility S&P 500 (VIX) — also known as the “fear index” — for bearish divergences.
The VIX is a market sentiment indicator that looks at options on the S&P 500 index to determine how much volatility investors anticipate in the market in the near future (If you want a detailed explanation of how the VIX is calculated, check out this white paper from the CBOE).
While volatility isn’t inherently a bad thing, it is often associated with dramatic market declines. So, most traders look to the VIX as a warning sign. When the VIX is moving lower, it shows traders are becoming less concerned about a potential bearish reversal. When the VIX is moving higher, it shows traders are becoming more concerned about a potential bearish reversal.
Bearish VIX Divergences
Divergences develop when the VIX is forming higher lows while the S&P 500 is forming higher highs, like we are seeing now (see Figure 1 and Figure 2).
If you are used to looking for divergences on technical indicators, this divergence on the VIX may look rather strange. After all, a bearish divergence on a technical indicator would still have higher highs on the S&P 500, but it would be accompanied by lower highs on the technical indicator — like the example in Figure 3 with the S&P 500 and the moving average convergence/divergence (MACD).
The reason the VIX divergence looks different is that the VIX is an inverted indicator. It moves lower when it is bullish, and it moves higher when it is bearish. If you flip the VIX upside down, suddenly it starts to look like a standard bearish divergence (see Figure 4).
Seeing a bearish divergence on the VIX tells us that Wall Street is growing increasingly concerned that a turnaround may be in store, but it is going to climb the wall of worry until it is absolutely forced to do otherwise.
We saw a similar bearish divergence form on the VIX as Wall Street climbed the wall of worry this summer before the October selloff on the S&P 500 (see Figure 5 and Figure 6).
While seeing a bearish divergence on the VIX is certainly not a guarantee that the market is going to reverse course, it should make us sit up and take notice of the increased potential that the market will do so.
We think we are still in the early stages of this bearish divergence on the VIX. That means we’re paying close attention to it, but we’re far from throwing in the towel on this bullish uptrend. Wall Street has proven itself to be quite resilient, and the bulls seem to be firmly in control of their own destiny.
We expect the beginning of 2015 be relatively stable on Wall Street.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.