Happy New Year! We may be in the second full week of 2020 but nostalgia has already set in from this time in 2018. Where ever you look, sentiment data appears to be full of froth as traders chase the strength that was 2019 into the new year. Hedge funds have reportedly under-performed so the narrative has been that they are pressing their bets early on in 2020 to provide some performance ‘cushion’ should election volatility perk its ugly little head come November.
In my Thrasher Analytics letter on Sunday night I started with a brief piece of commentary comparing surfing to trading. I’m by no means a surfer (I live in Indiana, not a lot of waves to catch here!) but I recognize the broad strokes of the sport. When in the water, surfers don’t attempt to ride every wave that comes their way. They must assess the risks associated with each approaching crest and evaluate their own personal tolerance and abilities.
Trading is the same with respect to market risk. We must evaluate each market trend and incorporate our respective tolerance for risk. ’19 for U.S. large cap stocks was a great year, but unfortunately we can’t extrapolate the past into the future. Sentiment data is suggesting things may be stretched at this point, the proverbial wave might be getting too high and coming in too fast to warrant an attempt to catch it. For some, it may make sense to wait it out and catch the next, for others, cowabunga!
Let’s look at some charts.
These first two charts come from Deutsche Bank. The first one shows the beta of risk parity funds. Remember, risk parity funds incorporate the market’s historical volatility into their decision making for equity exposure. When volatility is low, they ratchet up the beta with the expectation that low volatility will persist. They are now taking on a beta exposure similar to levels shown in early 2018, a period when volatility had also been quite low for an extended period of time…until it wasn’t.
Next, shows the equity exposure for CTAs which are momentum and trend-driven in their analysis. With the strong momentum of 2019, it’s not a surprise to see CTAs taking their equity holdings up near the historical high-end of the ten year range.
Jason at SentimenTrader recently shared this great chart, showing the bullish option volume rising to a near 20 year high. Jason noted that the amount of calls opened in the last week hit a new all-time high as well, breaching the prior high set in late-January ’18. Traders can’t seem to get enough juice from options with the unquenchable thirst for calls.
It’d be one thing if multiple corners of the market were chasing stocks higher with their equity exposure if we also had data to show they were hedging those bets with shorts, but that doesn’t seem to be case. Below is a chart showing the percentage of shares in the SPY ETF on loan (shares are loaned to short sellers). That figure has sunk to less than 2%, a 1-year low but not quite to January ’18 levels. It appears few traders are interested in shorting the S&P 500 ETF right now.
Looking at the S&P 500, the Daily Sentiment Index (DSI) has risen to 90% last Thursday, with the VIX DSI falling to 7%. No one is interested in volatility anymore. In January ’18 The DSI got to 96% for the S&P 500, so we aren’t quite back to those levels just yet but it’s not often 90% is eclipsed, as the chart below shows. For Volatility, the 5-day average stood at 11.5% on Friday, a rock bottom level of bullish sentiment for the ‘fear index’, a point we saw on January 25th ’18 and a few times in Q3 ’18.
All that being said, nothing matters until it does. Meaning, until price begins to react to these extreme readings in volatility and equity sentiment, the music will keep playing. The one caveat though, is it seems just about everyone has already jumped back into the pool – so whose left to get in? Some kind of resolution for this froth can be achieved through time or price. We had elevated sentiment last November and the market worked through it via time and a 3-day dip in stocks to kick off December. But I think the rubber band is more stretched this time around. This doesn’t mean we’ll replicate what took place in February ’18 but the wave is building, how we each chose to ride it or get out of the way is a personal decision.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.