Volatility And Liquidity
Since the Bull Market peak last fall, volatility has gone through the roof. “Volatility” is how market traders describe and measure the variation in prices or returns. Higher volatility is a direct reflection of greater investor uncertainty AND less liquidity. Volatility determines investor perception of risk.
“Liquidity” is related to volatility, but different. One refers to an asset as liquid when it’s easily converted into cash. Selling in a Bull Market is easy and fast. There are always more BUYERS than Sellers.
Selling in a Bear Market, however, is an entirely different matter. By definition, a Bear Market is a period characterized by MORE SELLERS than BUYERS. Bear Markets are less liquid (and MORE VOLATILE) than Bull Markets.
Extreme volatility is a symptom of poor liquidity, but can also be a CAUSE. The uncertainty that high volatility reflects ALSO reduces investor confidence. Thus, investors are less willing to commit funds.
The Volatility Index (VIX) is a market-based measure of uncertainty, FEAR or perception of risk. The VIX directly reflects investors EXPECTATIONS of prospective volatility. The HIGHER the VIX, the more that investors perceive imminent risk.
Markets peak at extremes of investor GREED when buyers are “all bought in” and overconfident. The converse is true, too. Bottoms are marked by FEAR and EXTREME risk aversion. At lows, the market has run out of Sellers. See “The Psychology of Investing”. (https://markonomics101.com/2018/10/08/the-psychology-of-investing/.
Volatility and illiquidity are the key traits of BEAR MARKET rallies. See “Characteristics of Bear Market Rallies”. (https://markonomics101.com/2018/10/17/characteristics-of-bear-market-rallies/).
Volatility Inversely Coincides With Market Tops And Bottoms
The VIX reflects expectations of future variation in the Standard & Poor’s 500 Index (SPX). Volatility indexes are also measured and traded for the Nasdaq 100 (NDX), Gold, the Dow Jones Industrials, Bonds and many other assets.
The Slide Show below illustrates the inverse relationship between market indexes and Volatility measures. In general, short term HIGHS in Volatility tend to coincide with short term LOWS in the index. The relationship is not perfect from a timing standpoint. LOW or HIGH volatility can persist for some time prior to a market reversal. Still, levels of Volatility are useful in “assessing the odds” that a trend has reached a turning point.
Some key takeaways from the SPX/VIX and NDX/VXN charts are as follows:
- Each Bear Market Rally (points 1, 2 and 3) has terminated at approximately the same levels of volatility. We are now approaching the levels that have pegged the last 3 short term peaks.
- Both SPX and NDX have made a series of LOWER HIGHS and LOWER LOWS. Unless and until the trend turns higher, the stock indexes remain in a BEAR Market.
- Neither the SPX nor NDX have retraced 50% of their Bear Market losses. Both indexes are just below Major Resistance.
More often than not, Bear Market rallies will recoup 40% to 60% of the prior decline. Half, or 50%, is simply a rule of thumb but a useful metric for setting expectations. (https://www.dummies.com/personal-finance/investing/technical-analysis/how-to-use-the-gann-50-percent-retracement-theory/).
Where’s The Volume?
Perhaps the most meaningful measure of liquidity is volume. Normally, Bull Markets are accompanied by INCREASING volume. Markets with low or no volume are, by definition, illiquid.
The Slide Show below further suggests that the ongoing BEAR MARKET rally is running out gas.
The key takeaways from these charts are the following:
- The Dow and SPX have rallied with DECLINING VOLUME. Low volume IS ILLIQUIDITY. The Bear Market rally is most likely the result of short-interest covering rather than deployment of new funds.
- Both indexes appear to be forming short term ROUNDED TOPS. This pattern forms when momentum begins to decline.
- The Dow and SPX are bumping up against their 50% Retracement levels. Both indexes face heavy resistance, which should preclude much more upside. They can be thought of as having used up their FUEL and vulnerable to a sudden shift in direction.
- Both indexes are only slightly above their rising Up Trend Lines. If either break below these lines, their patterns will turn BEARISH, again.
Individual Investors Renew Their Optimism
The lessening of FEAR indicated by the lower VIX is confirmed by Investor Surveys. The American Association of Individual Investor’s weekly survey shows a SIZABLE drop in PESSIMISM. (https://www.aaii.com/sentimentsurvey).
As of January 9th, investors calling themselves BULLS moderately exceeded BEARS, 38.5% to 29.1%. Both readings were near historical averages. The number of BEARS fell by a sizable 13% from 5 year highs in the previous survey.
When asked about 2019, 45% said 2019 would be UP versus 19% who predicted a down year. FEAR has been largely squeezed out of the markets. The circumstances for a renewed decline are in place.
Of course, nothing would preclude a further move higher, but odds are this Bear Market rally is nearing conclusion. The most prudent course of action is to reduce risk and build personal liquidity. Opportunities WILL arise, but they will be for the liquid. Will YOU be ready when the time comes?
For now, the BEST investment is INFORMATION. That’s our job.
Be Informed, Not Misled!