Going into the latter part of October, the equity markets are on pace for the least volatile month in history. Monday tied the record for the longest streak since 1928 without a drawdown of at least 3% at 241 days. The S&P is also in the middle of the second-longest streak of trading days without a 1% intraday move. The longest took place within the same rally; from Dec. 15 2016 through March 20, 2017.
We cannot pinpoint the exact cause of the absence of volatility, but we recognize there are several contributing factors, such as earnings growth, economic stability and the increasing popularity of algorithmic trading, which mitigates the impact of emotion in the marketplace. However, we cannot ignore the fact that, historically, volatility vacuums have always been followed by an uptick in volatility and often an accompanying stock market correction of various magnitudes -- some terrifying and others not worth mentioning.
To corroborate our premise and expectations of at least an uptick in volatility, which would increase the odds of an equity market correction or consolidation, we referred to the implied volatility charts in the Nasdaq 100 futures market, the S&P 500 futures, and crude oil futures. We are including crude oil volatility in our analysis because the last significant equity market pullback occurred at the hands of increased volatility and sharp declines in the oil market.
Thus, if volatility returns to commodities in general, but specifically oil, it will likely bleed into the equity markets, and vice versa. As a refresher, implied volatility is the measure of uncertainty traders are pricing into option values. Lower levels of implied volatility in the stock indices suggest investors are complacent, aren't interested in buying portfolio protection, and are generally ignoring market risks. Of course, when market participants are most comfortable is precisely when they should be most concerned.
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In crude oil, a low implied volatility reading suggests speculators are expecting oil prices to remain uneventful. They, too, are prone to big surprises when expectations of volatility dip to low levels. In short, options players in the stock and commodity arenas are ignoring Warren Buffet's advice to be fearful when others are greedy.
In the Nasdaq 100 futures, which differs from the widely tracked Nasdaq composite index in that it only includes the 100 non-financial leading market capitalization stocks listed on the Nasdaq exchange, implied volatility is approaching 12%. This level has been seen on a mere three other occasions in recent decades. While this alone doesn't guarantee the stock market is due for a breather, it greatly escalates the odds of one. After all, if investor complacency is at an extreme low, there is more room for panic than continued confidence.
Similarly, the S&P 500 futures markets are carrying an implied volatility just under 8%. An all-time low!
Implied volatility in crude oil is not at an all-time low, but it is at a highly discounted level relative to the historical norm.
In short, the odds of volatility getting significantly cheaper are slim. The seemingly imminent increase in volatility in oil or stocks favor the odds of a stock market pullback.
In addition to historically low volatility, there is a good chance the currency markets soon begin to interfere with the stock market rally. The current running correlation between the U.S. dollar and the S&P 500 futures has been a negative 86%. This means the dollar and the S&P close in the opposite direction nearly nine out of 10 trading sessions.
Obviously, this has worked in favor of stocks thus far, because the greenback has been in a slump, but according to Moore Research Center Inc., throughout the previous five years, the dollar has had a strong tendency to rally in late-October and early-November. If 2017 follows suit, it will be antagonistic to the S&P and Nasdaq rallies.
The weekly dollar chart is also pointing higher. In September, the dollar tested trendline support and successfully recovered. Since then, the greenback has managed to move steadily higher. Technical oscillators such as the relative strength index RSI are mid-range, suggesting momentum is positive and there could be room to run.
We see the dollar climbing to 95.80 in the short-run, but there is potential for a move back to 100.50 should resistance near 96.00 fail to hold. This would obviously be a significant headwind to the stock market rally.
Both the S&P and the Nasdaq have had an impressive run, there is no doubt about it. In fact, this bull is in contention for the longest of all time. The current leg of the bull market began on the morning following Election Day in the U.S., and the bulls haven't looked back since.
In the early months of the move, the Nasdaq lagged the S&P, but the tables have turned in recent months, causing the Nasdaq to take the lead. A handful of tech stocks took the Nasdaq 100 higher, and the S&P 500 went along for the ride.
The Nasdaq 100 futures have rallied roughly 29% since the November low, and the S&P futures have rallied 25% in the same timeframe. This could eventually work against the broader indices. Tech stocks are notorious for being relatively volatile; accordingly, if they are leading the charge, they could be exposing the S&P to a substantial amount of volatility if something goes wrong in tech-land.
In other words, the Nasdaq will likely be the first to show signs of cracking if the equity markets ever do go into correction mode.
Honing in on the individual monthly charts of the S&P and the Nasdaq, it is clear the bull is alive and well, but basic chart analysis reveals that the punchbowl could soon be running low. We typically look at weekly and daily charts, but for this particular analysis we wanted an even bigger picture and we weren't disappointed. It is easy to get caught up in the day-to-day stories in the financial markets, but it is important that we learn from history, because it repeats itself often.
The RSI, Relative Strength Index, on a monthly S&P 500 futures chart has reached 80 for the first time dating back to 1997 (a reading over 70 is rare and generally triggers some profit taking). Since 1997, we have seen the RSI on a monthly chart reach the 70s on three occasions (1999/2000, 2007, and 2014/2015). While these events weren't immediately followed by market downturns, the first two instances were eventually met with swift selling and the third could be best described as a slowing rally which did ultimately suffer a minor pullback.
Further, the current S&P rally has been running on a steep trajectory (too steep based on historical standards) and is nearing trendline resistance near 2600. This trendline resistance has held firm since the 2009 low and we expect it will continue to do so. The most impressive aspect of the chart is the fact that the uptrend can be held intact even if prices retrace into the mid-2100s or roughly 17%! Depending on how fast prices retrace, assuming they do, the uptrend support line comes into play near 2150, with an internal trendline at 2280.
The Nasdaq 100 futures are similarly overbought. Ironically, despite being a market leader, the index is slightly less overextended than the S&P in regard to technical oscillators. Nevertheless, there are signs the market is overheated that shouldn't be ignored. The RSI on a monthly chart of the Nasdaq futures is just shy of 80 at 77. This index also has a history of suffering setbacks, or at least consolidating, once the RSI moves above 70. In the Nasdaq, trendline support comes in near 5000, or roughly 18% underneath the market. Even a move to this level would keep the uptrend alive.
We aren't in the camp that believes long-term investors should make the rash decision of getting out of stocks altogether. Nor do we believe speculators should "bet the farm" on an imminent crash. However, we do believe now is a good time to reflect on where the markets have come from, how they have behaved in the past in similar circumstances, and proceed with both caution and logic. Everyone looks like a genius in a bull market, but it takes a true genius to set aside the need for greed in favor of being rational.