I recently published an article that discussed the possible bursting of the stock market bubble. (You can read it here.) In that article I made the argument that investors have become too complacent, and when that happens, you can usually count on volatility erupting and a change in market trend.
In this article I will delve more deeply into the idea of complacency and show you how my complacency indicator works. It has helped me to avoid some of the pain associated with markets that turn from bullish to bearish. I say "some" of the pain because no indicator is 100% accurate or perfectly timely. I just get an early warning that a change in investor sentiment, and thus a change in market direction, is not far off.
Realized Volatility
The last 75 trading days (that’s 3.5 months in real time) have been unusually calm (low realized volatility). But the big options traders (hedge funds, pension plans, endowments, etc.) are not fully buying the calm. They’re pricing in future future turbulence. Not panic, just an elevated level of implied volatility.
Daily moves have been muted. And the equity markets are pricing stability that may not be durable. A 12.0% realized volatility reading on the S&P 500 is well below long-term norms and consistent with investor complacency.
The VIX-Realized Risk Premium
First, I calculate the realized volatility of the equity market over the last 75 trading days. That number works out to be 12.0% when I annualize it, which is unusually low, The long-term average of realized volatility is ~15% per year.
This low reading does not, in my opinion, reflect a "healthy" calm. It's the kind of reading that you get late in bull market cycles. You also see this when investors have cut back on their normal hedging activities. (Or stopped hedging completely.)
Additionally, this low volatility reading may reflect the idea that investors are ignoring the macro uncertainty that surrounds us. Tariffs, inflation, the job market, a possible shooting war with Iran, ballooning debts and deficits, just to name a few.
Next, I find where the VIX index closed, which in today's case was 19.1. This number is already annualized, and it represents implied volatility, rather than realized volatility.
Finally, I subtract the realized volatility from the implied volatility to get the Volatility Risk Premium. Today the premium is 19.1 - 12.0 = 7.1. Historically, one would expect this premium to be in the 3-4 range. When it rises to 7 or higher, it signals elevated hedging demand. But the equity market is calm. I take this as a sign of complacency.
I call this spread between the Implied volatility in the options market vs. the realized volatility in the stock market the volatility risk premium.
Credit Spreads
For this part of the Complacency Indicator I look at the spread between junk bond rates and investment grade rates. This is my way of taking the temperature of the bond market to see whether complacency is present there as well.
In a normal, upward trending market, one would expect junk bond investors to demand a premium of about 4.75% over investment grade paper. Today the spread between these two types of bonds is 2.88% This tells me that bond investors are even more complacent than equity investors. They are:
- Reaching for yield
- Underpricing default risk
- Assuming economic stability
- Ignoring tail risks
Where are the bond vigilantes? With our national debt and budget deficits out of control, bond investors seem to be whistling past the graveyard. Bond vigilantes have been replaced by bond doves.
Margin Debt
Margin debt is a measure of investor sentiment and risk appetite. High levels of margin debt can signal confidence, but extreme readings may also indicate overconfidence and complacency, increasing the risk of market instability.
Margin Debt hit its seventh consecutive record high of $1.23 trillion in December. Let that number sink in for just a minute. Investors are on the hook for more than a trillion dollars in margin debt, which they will have to pay off if the market takes a serious downturn. This is yet another sign of complacency.
But here's the worrisome part: the combination of rising margin debt and falling market volatility is a classic sign of investor complacency. Investors are aware of the risks, but they are ignoring them and going all-in on equities and junk bonds.
The Complacency Indicator
My complacency indicator combines:
- Realized volatility - 12% today, which is very low historically.
- VIX-Realized Volatility spread - 7.1% today, showing that equity investors are ignoring risk.
- High Yield credit spread - 2.88 today vs. 4.75 historical median.
- Margin Debt trend - today it's rising while equity volatility is falling.
When 3 of these are flashing "calm" it means we are in a behavioral complacency market regime. This can go on for months, but eventually calm will turn to turmoil.
What To Do Now
First, don't panic. As I said, this complacency regime can go on for months. Make a plan for how you will deal with the next bear market. Will you raise cash? If so, what will you sell?
Will you hedge with options? Which options specifically? What about using an inverse ETF like SH? This ETF is the mirror image of the S&P 500 index and it tracks very well.
Will you buy gold, silver, crypto, or commodities? These assets tend to zig when the equity market zags, but you can't always count on them to come through.
Will you do nothing? If you are young enough to be a steadfast buy & hold investor, you can just ride out the storm. But it's always a good idea to have some cash at the ready to take advantage of bargain prices.
Whatever you plan to do about the next bear market, having a written Plan B is well worth the effort it takes to write. My Plan B is in writing. I'm on alert right now, but I have only raised 10% cash so far. If my bear market model gives a stronger signal, I will raise more cash. And if the wheels really start to come off the equity roller coaster, I will use the SH ETF to protect my downside.
What will you do?