Don’t Fall Asleep At The Wheel

Don’t Fall Asleep At The Wheel

Happy new year!

As we begin 2021 everything in equities land looks very bullish.

The S&P 500, Nadsaq and Dow Jones are all at all-time highs. The Russell 2000 and Dow Transports are within points of their recent all-time highs.

We have stimulus cheques going out, earnings season is just two weeks away, the Fed has got our backs…so, what’s not to like?

Look, I don’t want to get all bearish here. As I have said many times, markets that are at all-time highs are the most bullish markets to trade.

But there are a couple of warning signals I want to share with you.

VIX Curve

The first warning I want to share with you is the VIX forward curve.

The VIX Forward Curve is in steep contango
Vix CurveVIX Curve

The chart above shows the forward curve – also known as the term structure – of VIX futures contracts. The curve comprises prices of individual VIX futures contracts of different expiration dates.

When the curve is upward sloping from left to right, we call this situation contango. This is the current state of VIX futures, and it indicates the cost of hedging the S&P500 via put options is higher in February (and beyond) than it is in January.

This fits well with the theme of early January being a seasonally bullish time for the stock market due to phenomena such as “The Santa Rally” and “The January Effect”.

What (relatively) cheap volatility in January indicates is a lack of desire for people to hedge stock market risk out to 20 January 2021.

The jump up in the price of February VIX futures shows an increased preparedness for people to pay up for volatility next month.

SKEW

The Skew Index (SKEW) measures perceived tail risk in the S&P 500. It is calculated by calculating the cost of puts that are two or more standard deviations out of the money, with their corresponding call options.

SKEW typically oscillates between 100 and 150. The higher the reading, the higher the perceived risk of a tail risk event.

Readings of 150 indicate that hedge funds are paying up for put options that are two or more standard deviations out of the money. These put options are 1.5x more expensive than their corresponding call options.

The SKEW Index is near the top of its typical range
The SKEW is near the very top of its typical range

The SKEW is presently at ~148, indicating a preparedness by hedge funds to pay up for tail-risk hedges.

The SKEW is not a precise timing tool by any stretch of the imagination. But readings this high often coincide with short-term market tops.

Market Breadth

We have also seen a decline in one measure of market breadth. the percentage of stocks trading above their 20-day moving average has declined from 81.9% in early December to 57.3% currently.

This indicates a declining number of stocks are in a short-term uptrend. Not what we ideally want to see in a market that has continued to make new highs during this time period.

Conclusion

These warning signs indicate the stock market could be nearing a healthy pullback. I don’t think we have seen the top of the market for this cycle and I expect higher highs are in our future. But right now would seem a bad time to be complacent if you are excessively long the market and/or trading with leverage.

The trend is up and so my portfolio remains long-biased. But I do have hedges in place to protect me against a potential pullback here.

If you would like to learn more about the VIX, the SKEW and a whole host of other market internals and learn how to hedge your portfolio, please click here to join the waiting list for my new “How To Hedge” course, to be released later in January.

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