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To say that complacency has reigned in the last few months is an
understatement. Volatility as measured by the CBOE Volatility Index
(VIX) has fallen 60% since October and 20% since the start of 2012.
To put into context just how much volatility has fallen since the
latest rally kicked off in October, the 10-year chart of the S&P 100
Volatility Index (VXO) is shown below. The VXO is an excellent frame of
reference for the absence of widespread fear in this market in recent
months. As you can see, volatility is approaching historically low
levels not seen since before the credit crisis began.
Options traders often use readings in the VIX and VXO to gauge whether
investors have become overly complacent. It has been noted that when
volatility subsides to historically low levels like we’re now seeing,
it tends to generate its own reversal (based on the contrarian principal
that the crowd can’t be on the right side of the market’s trend for
long).
But the old saw that retail investors “can’t be right for too
long” can sometimes be misleading. Check out the years 2004, 2005 and
2006 in the above chart and you’ll see what I mean. These were low
volatility years by historical standards and the market remained in
strong hands for the most part during this 3-year period. The reason for
this sustained period of low volatility can be attributed to the
position of the longer-term yearly cycles during 2004-2006. The 6-year,
10-year 12-year cycles were either up or peaking during much of this
time period. This doesn’t even take into account the influence of
monetary policy and bank credit factors which were then in effect.
On a shorter-term basis, volatility is largely influenced by the weekly
Kress cycles, or more specifically, by the interaction between the
peaking and bottoming cycles. Cyclical cross currents create market
volatility and this volatility is reflected by an increase in the VIX.
VIX has been abnormally low in recent weeks, which has coincided with an
increasing level of investor complacency. Again, we aren’t justified
in assuming that because complacency is high and volatility is low that
the intermediate-term uptrend for stocks is doomed. Rather, we must look
for answers from the weekly cycles.
The nearest weekly Kress cycle of intermediate-term consequence is
scheduled to peak next Friday, Feb. 17 (plus or minus). A second interim
weekly cycle will peak around March 9. There is a greater than average
chance that one of these two cycles could put a significant peak on the
market, though we won’t know for sure which of the two dates is most
likely to be the interim high until closer to the cycle peaks.
The question we need to examine is whether the upcoming cycle peak next
week will put the interim peak on the market. While we must be prepared
for this possibility, I don’t believe the next few days will witness
anything beyond a short-term market peak, which in turn would offer the
market a much-needed breather after its run-up of the last several
weeks. There is still a strong current of internal momentum behind this
market which argues against a major interim top happening right now.
The following chart shows the extent of this strong intermediate-term
momentum. The blue line is the sub-dominant interim momentum for the
NYSE stock market while the red line is the dominant interim momentum.
Both are still rising at a solid rate of change and should act as a
support against any attempt by the bears to raid this market in the
coming days while the first of the two weekly cycles peak.
Although the broad market still enjoys a strong measure of underlying
support from this internal momentum, volatility looks to be on the rise
in the coming weeks. The CBOE Volatility Index (VIX) broke out
decisively above its 15-day moving average for the first time since
November as you can see here.
Most of the internal momentum indicators which comprise the HILMO index
are still in an upward trend. One indicator that is diverging from the
rest is the dominant longer-term momentum indicator (below), which is
the longest of the internal momentum indicators in the HILMO index. The
indicator has made a series of lower highs as you can see here and has
just re-entered negative territory as of Friday, Feb. 10.
The interplay between the declining longer-term momentum and the rising
intermediate-term momentum discussed previously is likely to create some
volatility in the weeks ahead. Volatility was extremely low in recent
weeks, mainly because NYSE internal momentum was synchronized to the
upside. Now that this is no longer the case, the friction created by
these internal cross-currents typically brings about increased
volatility, which is normal around a weekly cycle peak. Thus we can
probably expect to see more an increasing amount of volatility from
here, especially after the March cycle peak.
As an accompaniment to the loss of cyclical support within the next few
weeks, we should also expect to see a return of Wall Street’s fixation
on the eurozone debt drama. Investors have gotten a reprieve from the
constant bombardment of negative headline over the Greek and Italian
debt crises. That’s typical of a market environment were the weekly
cycles are synchronized to the upside – in such periods as we’ve
experienced the last few weeks, good news tends to dominate the
headlines and bad news is put on the backburner.
With the return of cycle-induced volatility we can expect to see the
financial press fixating on bad news once again. And the media won’t
have to search far in order to find something negative to fixate on: the
“Greece trap” is the most obvious choice.
After confirming an immediate-term buy signal just three days into the
New Year, the SPDR Gold Trust ETF (GLD) has closed below its dominant
immediate-term 15-day moving average for the first time this year. GLD
advanced 8% from its initial buy signal in early January to its recent
peak on Feb. 2. On balance, an 8% rally from an immediate-term buy
signal is typical, especially when internal momentum is rising (as it
was until late January).
The latest close under the 15-day MA technically qualifies as an
immediate-term sell signal for GLD, though there’s still a chance this
signal will soon be reversed. How gold reacts to the upcoming Greek
bailout vote will set the tone for the weeks ahead.
Over the years I’ve been asked by many readers what I consider to be
the best books on stock market cycles that I can recommend. While there
are many excellent works out there on the subject of technical and
fundamental analysis, chart reading, etc., precious few have addressed
the subject of market cycles. Of the relatively few books on cycles that
are available, most don’t even merit mentioning. I’ve read only one
book in the genre that I can recommend – _The K Wave_ by David Knox
Barker – but even that one doesn’t deal directly with stock market
cycles but instead with the economic long wave. I’m pleased to
announce, however, that after nearly 10 years of research and one year
of writing, I’ve completed a book on the subject that I believe will
meet the critical demands of most cycle students. It’s entitled, _The
Stock Market Cycles_, and is available for sale at:
Clif Droke is the editor of the three times weekly Momentum Strategies
Report newsletter, published since 1997, which covers U.S. equity
markets and various stock sectors, natural resources, money supply and
bank credit trends, the dollar and the U.S. economy. The forecasts are
made using a unique proprietary blend of analytical methods involving
cycles, internal momentum and moving average systems, as well as
investor sentiment. He is also the author of numerous books, including
most recently “The Stock Market Cycles.” For more information visit
