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Volmageddon for the New Year?

Let’s look at how ‘recency bias’ is stirring up fears of another volatility shocker like we saw in the start of 2018.

Note: My next column will be after the new year, as I am off through Jan. 1. Happy New Year to all!

The Market

Leading up to Christmas – the day this was written – it seemed many were dying to compare this market to the relentless run into year-end 2017. And we know that that run ended up with what became known as 'volmageddon.'

You can blame this on all the "recency bias" going on these days. Recency bias is when a particular move in the market is so fresh in your mind that you look for the market to repeat that pattern. We saw a lot of this as we headed into October this year, as so many were looking for a repeat of the fourth quarter of 2018. I wrote about this recency bias situation back then, noting that we rarely repeat something so fresh in our minds.

Recency bias tends not to work out. I'm not saying we won't get a bout of volatility around January, but to look for the same volatility event as we had at the start of 2018 would be unusual. You know that expression about lightening: It rarely strikes the same place twice.

So, let’s look at that late 2017 and early 2018 time period to see if there were any similarities.

Let me just start with the chart of the S&P 500. The first thing we notice is December was much more up and down in 2017 than it has been now (boxed on the chart). In the 2017, we had a minor pullback in early December, similar to what we saw this year, but the relentless rise off that low this year looks nothing like two years ago to me. Back then we had gaps that got filled. Back then we had days where the market closed on the low. We've seen none of that this year, although from the autumn low through year-end, the S&P was up almost the same amount then as it has been now. So there's that.

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Keep in mind that the relentless rise in the S&P back then came in January. So let's look at the stocks making new highs. As we headed into year-end 2017, new highs were good, but not great; they were definitely not expanding beyond the Thanksgiving level. They had stalled out at 300. But now look at January: The peak at just over 400 came in the second week and it was lower highs for the rest of the month -- despite that relentless rise in the S&P. That was a clear negative divergence.

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Now we have a market where we can't even get to 300 new highs. The peak was last summer, but since the last few days the S&P has been sideways the drop off in new highs is standard. But should the S&P have another decent push upward with new highs falling off into such a rise, then it would be similar to around January 2018.

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When it comes to breadth you can see it peaked in mid-January 2018. As we headed into that high in the S&P late in the month, breadth was already weakening. So far there has been no weakening of breadth yet.

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The McClellan Summation Index peaked and rolled over mid-month January 2018 as well. As of now it continues to rise.

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One of the more interesting charts to me is the ratio of the iShares Russell 2000 Index (IWM) - Get Free Report to SPDR S&P 500 exchange-traded fund trust (SPY) - Get Free Report from back then. It peaked in October. It stayed in a steady downtrend that entire fourth quarter of 2017.

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Now we have this ratio holding its own. You can see that if it can ever get over that .52 area, it will make a higher high and will cross the (not shown) downtrend line that I have highlighted here countless times. So, this picture is different in that the small caps were not having nearly as much fun then as they are now.

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There is one chart that is almost exactly as it was in January 2018: the 10-day moving average of the equity put/call ratio. As you can see it doesn't get down here often. This is a five year chart.

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But I want to show you another period when it got down this far; it was actually lower than the current reading of 52%. It tagged 49% in the spring and summer of 2014. The market churned for another month - with an upward bias, then corrected, rallied and then had a serious correction in the fall. So not all super low readings must least to a blow up in volatility, sometimes it just leads to a normal correction.

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So what's the upshot of all of this? December 2017 doesn't look similar to December 2019. There were warning signs in January 2018 with fewer stocks at new highs, breadth falling off and the McClellan Summation Index rolling over. I suspect they will warn us again since that is what they are supposed to do.

The biggest concern now for the market is sentiment is giddy and complacent.

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