Over the last few weeks, we have shared some of our concerns about the market — falling margins, slowing manufacturing, yield inversions, etc.
We’ve also covered some of the issues traders are talking about that aren’t likely to have a long-term or predictable impact on the major indices — the outbreak of the coronavirus from China, the Democratic presidential primary, Brexit.
So far, it appears that our generally positive outlook was justified, if perhaps a little overly cautious.
However, we still recommend maintaining a careful stance because most of the fundamental issues facing the market remain unchanged. In this week’s update, let’s do a quick review of some potential trouble spots in market sentiment and what might motivate a shift in our outlook in either direction.
Yields Remain Frustrating
Lately, you may have seen headlines in the financial press about long-term Treasury bond prices falling again.
Although the yield curve — comparing the 10-year yield to the 2-year yield — hasn’t inverted since last August, falling long-term yields are worrisome on their own because of their status as a leading indicator for minor (and sometimes major) corrections in the market.
As you can see in the following chart, the yield on 10-year U.S. Treasury bonds, as represented by the CBOE 10-year Treasury Note Yield Index (TNX), has been falling since just before the Christmas holiday. However, prices on the S&P 500 have been rising during that period.
Historically, a divergence like this that lasts for more than a month has a 74% chance of ending with a 7%-15% correction in stock prices within 60 days. There is a lot of variability in the data, but the pattern is reliable enough to warrant watching the market closely.
The last time we saw this sort of divergence was in the third quarter last year when the market pulled back against resistance twice in a row.
Risky Assets Like IWM and XLP Are Underperforming
A confirmed bullish rally is usually led by the riskiest asset classes, like small-capitalization stocks, high-yield bonds and emerging-market stocks. Currently, those asset classes are lagging safety assets like Treasury bonds and large-cap stocks.
As you can see in the following chart, small-cap stocks (light blue), as represented by the iShares Russell 2000 ETF (NYSEARCA:IWM), are still trading below their recent highs. On the other hand, consumer staples (candles), as represented by the Consumer Staples Select Sector SPDR Fund (NYSEARCA:XLP), have been setting new records this week.
The positive takeaway in a situation like this is that at least investors are taking on new risk — even if it is in the safest sectors.
However, in our experience, if this second divergence continues, we will likely experience greater volatility in March. A very similar situation occurred just prior to the volatility we experienced in the third quarter last year. It’s also similar to the situation right before the bear market in late 2018.
One of the ways we can get an internal view of the market is through sentiment indicators that look at derivatives pricing for signs of stress. For example, one of our favorites is the CBOE SKEW index, which measures the pricing of put options on the S&P 500. Investors use puts to hedge against risk. If the SKEW is high, investors are hedging, meaning they are nervous.
Sometimes the SKEW index can be very wrong, but when it reaches extremes it is usually correct. The spike in the SKEW that occurred on Dec. 19, 2019 turned out to be a false alarm. But our concern is that the lows on the SKEW haven’t returned to normal levels. Instead, they continue to rise with the market.
As you can see in the following chart, the SKEW is still at moderate levels. But, the floor for the index is higher than it has been since the fall of 2018. This indicates that option prices remain elevated and big traders are still keeping their hedges close.
The Bottom Line
We don’t bet against the market trend, so our outlook remains positive for now. But this update was a chance to explain why we feel a cautious approach is best. We should increase our tolerance for adding risk if rates start to rise, risky assets begin outperforming again or sentiment begins to improve.
Conversely, if the indicators we have discussed continue to deteriorate, we will want to be a bit more aggressive about hedging our own risk. We may even want to seek some opportunities to the downside.
One of the advantages we have as option traders is our ability to be flexible about how much risk we are taking on and our capacity to determine what that risk looks like.
This is especially important right now because it gives us the opportunity to harvest extra premium from the options market.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it. John & Wade do not own the aforementioned securities.