By Anthony Mirhaydari
With the Dow Jones Industrial Average (DJI) piercing through 11,000, everything seems to be going right. The economy is on the mend. Spendthrift European politicians are bailing each other out. And the standard measure of stock market volatility expectations, the CBOE Volatility Index (VIX), which is based on S&P 500 (SPX) options trading, has fallen to levels not seen since the summer of 2007.
Realized volatility has actually hit lows not seen since December 2006. After stocks set a low back in February, just three of the 38 trading days that followed have featured a change in the Dow Industrials of 100 points or more. Compare that to rough-and-tumble period between January and February that saw no less than 13 100-point swings. So it’s all sunshine, lollipops and stock price appreciation right?
To be sure, investors are feeling very confident. But have they become complacent?
The short-term picture sure looks vulnerable. Hot shot traders like to keep track of what’s known as the “volatility term structure,” which measures short-term volatility expectations — the VIX — versus medium-term expectations — CBOE S&P 500 3-Month Volatility Index (VXV). When the relationship of short- to medium-term expectations drops to the lows it is at now, it has tended to mark a top for the stock market. This was a good indicator of trouble back in January.
Put/Call Ratio
Another way to gauge investor sentiment is to look at the ratio of equity put options to call options being traded on the CBOE in Chicago.
I use the 21-day moving average of the put/call ratio to smooth the result.
When this measure falls, it’s a sign investors are feeling increasingly confident and are using more and more call options to express their bullish sentiment. The opposite is true when the ratio is rising.
Right now, the put/call ratio is at its lowest levels since early 2004, which, like now, was a period of economic recovery and ultra-low interest rates.
The lower segment of the chart shows the S&P 500. You can see how after the big plunge in the put/call ratio in 2004, stocks went on to trade in a sideways consolidation for the better part of the year. While there is certainly nothing keeping the put/call ratio from dropping further, or stocks from continuing to rise, the fact that call option trades are becoming so crowded suggests now may be the time to start looking for opportunities on the short side for the traders among you.
Back to the VIX
Over the long-term, the decline in the VIX isn’t something to be worried about. It merely represents the transition from financial crisis and economic recession to expansion and growth; from bear market to bull market. As you can see in the chart below, a drop in the VIX below 15 have accompanied the last two bull markets as a “buy the dip” mentality took hold. This helped smooth out the market’s jumpiness and pulled the VIX down.
To close, I expect a period of near-term choppiness as the stock market pauses to consolidate the incredible run higher we’ve enjoyed during the past two months. But by no means should we be worried about a more significant market top being formed. Instead, use the opportunity to transition out of bonds and increase your portfolio allocation to stocks.
Focus on leaders within cyclical sectors like energy, materials, technology and industrials. Easy exposure can be had through sector ETFs including the Energy Select Sector SPDR (XLE) and the Industrial Select Sector SPDR (XLI). Bank stocks also look attractive, specifically insurance and regional banks. Be sure to look at the KBW Insurance SPDR (KIE) and the KBW Regional Banking SPDR (KRE).
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