Stock Selling Unleashed!

The unnaturally-tranquil stock markets suddenly plunged over this past week. Volatility skyrocketed out of the blue and shattered years of artificial calm conjured by extreme central-bank distortions. This was a huge shock to the legions of hyper-complacent traders, who are realizing stocks don’t rally forever. With stock selling unleashed again, herd psychology will start shifting back to bearish which will fuel lots more selling.

As a contrarian student of the markets, I watched stocks’ recent mania-blowoff surge in stunned disbelief. On fundamental, technical, and sentimental fronts, the stock markets were as or more extreme than their last major bull-market toppings in March 2000 and October 2007! I outlined all this in an essay on these hyper-risky stock markets on 2017’s final trading day. The ominous writing was on the wall for all willing to see.

January’s extreme surge in the US stock markets made this selloff case even more likely. Mid-month in another essay I warned, “The stock markets are now dangerously overbought, implying a major selloff is probable and imminent. … Such extremes are very unusual and never sustainable for long, signaling major selloffs looming.” So the fact these crazy stock markets finally rolled over wasn’t a surprise at all.

But I was awestruck at the sheer violence of what happened last Friday and the subsequent Monday, it was very odd. Even though the countless market extremes argued strongly for a major selloff, they tend to be much more gradual initially off bull-market peaks. So it was fascinating to watch all this unfold in real-time with my data feeds and CNBC. Students of the markets live for anomalous exceedingly-rare events!

The igniting catalysts were multilayered. The US flagship S&P 500 broad-market stock index (SPX) had blasted to a dazzling new all-time record high on Friday January 26th. It was stretched a mind-boggling 14.0% over its key 200-day moving average, which itself was high and steeply rising! The 8.9-year-old stock bull that had powered 324.6% higher felt unstoppable. Traders were universally convinced it would continue.

But just a couple trading days later on Tuesday January 30th, significant selling emerged. That morning Amazon, Berkshire Hathaway, and JP Morgan declared they were going to form a healthcare company. That unanticipated news way out of left field crushed the major healthcare stocks, hammering the SPX 1.1% lower. That was actually a significant down day by recent standards, the worst seen since mid-August.

With euphoric bullish psychology dented, Jobs Friday arrived a few trading days later on February 2nd. That official monthly US jobs report saw a modest headline beat, but the big news came on the wages front. Average hourly earnings beat expectations by climbing 2.9% year-over-year, the hottest read on wage inflation since June 2009. That triggered inflation fears with the 10-year Treasury yield already at 2.78%.

Higher prevailing interest rates are a huge problem for bubble-valued stock markets. The SPX had just left January with its 500 elite component stocks sporting a simple-average trailing-twelve-month price-to-earnings ratio way up at 31.8x! Historical fair value is 14x, twice that at 28x is formal bubble territory. In a higher-rate environment, extreme valuations are far harder to tolerate. So the stock markets sold off.

A week ago Friday the SPX slid all day long to close at a major 2.1% loss. That proved its biggest down day since way back in September 2016, before Trump won the election and the resulting extreme stock rally first on Trumphoria and later on taxphoria. Something was changing, the unnaturally-low volatility regime was crumbling. That left speculators and investors alike very nervous heading into last weekend.

It had been an all-time-record 405 trading days since the SPX’s last 5% pullback, unbelievably extreme. So that selloff really struck a nerve, I started to hear from casual acquaintances I hadn’t spoken to for years. At a friend’s Super Bowl party Sunday night, once the guests I didn’t know found out what I do for a living I felt like a celebrity. We spent the first quarter talking about the markets, people were really concerned.

Monday the 5th was extraordinary, a record day in some respects. SPX futures were down less than 1% in pre-market trading, nothing wild. But once the US stock markets opened, the selling started gradually snowballing. It greatly intensified around 3pm, with the SPX plunging from -2.3% to -4.5% on the day in literally 11 minutes! There was no news at all, it simply looked and felt like cascading stop-loss selling.

All prudent traders put trailing stop-loss orders on their stock positions. They are an essential measure to manage risk. Once a stock falls a preset percentage from its best level achieved during a trade, that position is automatically sold. In big stock-market selloffs, as stop losses are sequentially hit they feed into the ongoing selling. The more stocks fall, the more stops triggered, the more sell orders fuel the maelstrom.

The SPX bounced a bit, but still plunged a whopping 4.1% on close Monday! That was a serious down day by any standard, actually the worst since way back in mid-August 2011 which followed Standard & Poor’s downgrading US sovereign debt. Everyone takes notice when stock markets suffer their biggest daily drop in 6.5 years. That really changes collective psychology, shattering the euphoria rampant in January.

But amazingly that SPX plunge wasn’t the most-interesting thing Monday. The implied volatility on SPX options is tracked in the famous VIX fear gauge. It skyrocketed a stupendous 125.8% higher that day, its largest daily spike ever witnessed! That wreaked colossal havoc in the short-volatility market. Since Trump’s election win, more traders and capital have flocked to bet on the idea that volatility will keep falling.

Students of market history knew that was an absurd bet before Monday’s spike. Stock-market volatility has always been cyclical, just like stock prices. Exceptionally-low or -high volatility levels always mean revert back to normal. So betting that the record-low stock volatility in recent months would keep going even lower was a foolish, suicidal bet even before Monday. That epic VIX spike totally gutted these guys.

There are, or were, extraordinarily-risky inverse-VIX exchange-traded notes. These were designed to rally when volatility fell, some even with leverage which traders liked to further amplify with their own margin. One of the leading inverse-VIX ETNs was XIV, which is VIX spelled backwards. It had closed at $129.35 per share on Thursday February 1st, but by this Tuesday it had imploded 94.3% in a termination event!

All these inverse-VIX ETNs were shorting VIX futures, so they had to become massive buyers on that sharp SPX selloff to close out those devastated positions. On Monday the banks sponsoring these crazy ETNs had to buy an extreme record 282k VIX futures contracts! That catapulted the VIX itself to 50.3 on Tuesday morning, about as high as it ever gets outside of actual crashes and panics. What a wild ride!

That begs the question what happens next? This stock-market-selling and volatility shock happened at a time when stock markets were already very precarious. Such an extreme event has to start altering herd psychology. This first chart looks at the SPX superimposed over the VIX during the last few years, both on a closing basis. Once serious selling starts out of toppy stock markets, it usually portends much more coming.

This week’s stock selling unleashed emerged in some of the most-toppy stock markets ever witnessed. Again the average SPX-component TTM P/E leading into it was a bubble-valued 31.8x! Again the SPX had stretched 14.0% above its 200-day moving average, some of the most-overbought conditions seen in all of SPX history. The SPX had rocketed vertically for most of January in popular-mania-grade euphoria.

The future impact of stock selling being unleashed really depends on the market conditions that birthed that selling spike. If stock prices were near multi-year lows leading into selling spikes, with valuations lower than their historical average of 14x earnings, these events can mark selling climaxes before major reversals higher. But unfortunately the exact opposite was true leading into our current sharp SPX plunge.

Coming out of what looked and felt like a mania blowoff top, this past week’s serious selling is surely an ominous omen. Stock markets can’t rally forever, yet that’s exactly what they seemed to be doing since Trump’s surprise election victory. Between Election Day and late January’s latest record high, the SPX had soared 34.3% higher in just 1.2 years! And that span was incredibly extreme with record-low volatility.

Again as of last Friday it had been an all-time-record 405 trading days without a single 5% peak-to-trough SPX pullback. That’s 1.6 years! Nothing like that had ever happened before. Technically a pullback is a 4%-to-10% selloff in the stock markets on a closing basis. The last pullbacks were minor, a 4.8% one in late 2016 following a 5.6% one in mid-2016. Those were the last material selloffs in the SPX before this week.

Periodic selloffs to rebalance sentiment are essential to keeping stock bulls healthy. The longer markets go without significant selloffs, the more greed and complacency multiply. Traders forget that stocks fall too, and their hubris leads them to take all kinds of excessive risks. Like betting that record-low volatility will persist indefinitely. The leveraged speculation eventually gets so extreme that it threatens the entire bull.

My favorite analogy on this is forest fires. Officials love to suppress natural wildfires to protect structures. But the longer firefighters put out every little wildfire, the denser forest underbrush gets. This fuel source grows out of control, eventually leading to a conflagration far too extreme to put out. Rather than having a bunch of smaller wildfires to keep fuel in check, suppression eventually guarantees a super-destructive hell fire.

Periodic pullbacks and corrections in stock markets allow the underbrush of greed to be burned away before it gets thick enough to become a systemic risk. Traders naively believe levitating stock markets are less risky, but the opposite is true. The longer a span without a serious selloff, the higher the odds one is coming soon. Normal healthy bull markets actually suffer 10%+ corrections once a year or so to keep balance.

It’s been 2.0 years since the last actual SPX correction, which bottomed in early 2016. The lack of both smaller pullbacks and larger corrections let complacency grow unchecked into greed, euphoria, and even hubris recently. And these emotional extremes have to be mostly burned away for this bull to have any hope of eventually heading higher. The only thing that can eradicate widespread greed is major stock selloffs.

After Monday’s serious 4.1% plunge, the SPX was still only down 7.8% since its peak just 6 trading days earlier. While that is unusual speed to see such a decline, it still only ranks towards the high end of mere pullback territory. We hadn’t even hit a correction yet at 10%, and they can stretch as high as 20%. The SPX’s last corrections ran 12.4% over 3.2 months in mid-2015 and 13.3% over 3.3 months into early 2016.

Given the extreme overvalued and overbought conditions leading into this past week’s plunge, there’s no way even that was enough to rebalance away the euphoric sentiment. So it’s all but certain the SPX will grind lower in the coming months, heading down well over 10% into deep correction territory. At 10% the SPX would merely be back to early-November levels, merely erasing the recent mania-blowoff surge.

If this correction approaches 20% as it really ought to, that would drag the SPX all the way back down to 2298. Those levels were first seen just over a year ago in late January 2017. That would reverse the lion’s share of the entire past year’s taxphoria rally, wreaking tremendous sentiment damage. But don’t forget corrections tend to take a few months, not a few days. So the selling is way more gradual than Monday’s.

That extreme 50 VIX spike Tuesday morning must be considered. Again that’s about as high as the VIX ever gets in normal corrections, implying the immediate selling pressure should have abated. The only times higher VIX levels are briefly seen is after crashes and panics. A crash is a 20%+ drop in just two trading days from very-high stock-market levels. This past week’s Friday-Monday selloff wasn’t even close.

Crashes are exceedingly rare in history, and next to impossible today given the widespread use of stock-market circuit breakers. They effectively close markets for a time after intraday selling milestones are hit. Today the SPX has levels triggered at 7%, 13%, and 20% intraday declines. The trading halts depend on when these declines occur within a trading day, before or after 3:25pm. They would slow crash-grade plummets.

Panics are steep 20%+ selloffs within two weeks, extreme but much slower than crashes. They tend to cascade from lows out of late-stage bear markets to climax them. They are very rare too, with 2008’s being the first formal one since 1907. The VIX can temporarily soar above 50 in crashes and panics, but those extremes never last for long. In normal market conditions, a 50 VIX spike should mark an absolute bottom.

But the problem this week is Tuesday’s extreme VIX spike was the result of panic buying of VIX futures to liquidate those inverse-VIX ETNs. That has never happened before. Without that dynamic, the VIX likely wouldn’t have gone much above 30. That too implies this stock-market selloff still has plenty of room to run. So the stock selling unleashed is likely to persist over a few months at least, despite the VIX spike.

Given the extremes in these stock markets in late January, I still suspect the odds heavily favor a new bear market over 20% instead of a bull-market correction. I presented this compelling SPX-bear case in late December, and don’t have room to rehash it here. Normal bear markets tend to cut stocks in half over a couple years or so, 50% SPX losses. That works out to a gradual average selling pace of 0.1% per day.

The last couple SPX bears give an idea of what to expect in the inevitable next bear after such an epic stock bull. The SPX fell 49.1% over 2.6 years ending in October 2002, and 56.8% over 1.4 years that climaxed in March 2009. A 50% SPX loss, which is conservative since bears tend to be proportional to their preceding bulls’ sizes, would drag this index back to 1436. That’s September-2012 levels, a long way down!

No one knows whether this stock selling unleashed will culminate in a bull-market correction under 20% or a new bear market over 20%. But either way, speculators and investors ought to swiftly boost their anemic portfolio allocations to gold. The record-high stock markets in recent years have led to radical gold underinvestment. Gold tends to rally on balance when stocks fall, it’s the ultimate portfolio diversifier.

As this final chart shows, after the last SPX correction ending in early 2016 gold surged into a major new bull market. Hyper-complacent stock traders suddenly realized that they needed to own gold to diversify their stock-heavy portfolios. That gold bull has persisted, powering higher in a strong uptrend ever since despite this past year’s extreme taxphoria stock-market rally. A new SPX correction will work wonders for gold.

That last SPX correction into early 2016 wasn’t large at just 13.3%. Yet that was still enough to motivate complacent investors to flock back to gold. Their heavy buying catapulted gold 29.9% higher in just 6.7 months! Gold turned on a dime from deep 6.1-year secular lows because a major stock-market selloff finally convinced investors to up their meager gold allocations. Every investor should have 5% to 10%+ in gold.

Just a week ago that ratio was likely only running around 0.14% based on the values of that leading GLD gold ETF and the collective market capitalizations of the 500 SPX companies! So with gold allocations essentially zero late in an extreme stock bull, there’s vast room for massive capital inflows into gold in the coming years as investors rebalance their portfolios. Gold thrives for a long time after major stock selloffs.

The gold buying isn’t instant when the SPX falls though, as traders need time to process the drop and its likely implications. Back in early 2016 stock investors really didn’t start aggressively buying GLD shares until the SPX suffered multiple big down days. The SPX fell 1.5%, 1.3%, 2.4%, and 1.1% on separate trading days in a single week before gold buying resumed. More big SPX losses soon accelerated these inflows.

If you don’t have a significant gold allocation in your portfolio, you ought to get buying. It can be done with physical gold bullion or GLD shares. If you want to leverage gold’s bull market that will accelerate following a major stock selloff, consider the stocks of great gold miners. They tend to amplify gold upside by 2x to 3x due to their fantastic profits leverage to gold. The precious-metals sector thrives after stock selloffs!

Finally the stock selling unleashed is likely just beginning due to what the major central banks are doing this year. The Fed’s unprecedented quantitative-tightening campaign to start reversing its trillions of dollars of QE liquidity injected that levitated stocks for years is accelerating throughout 2018. At the same time the European Central Bank slashed its own QE campaign in half until September, when it may cease entirely.

Between the Fed’s QT and ECB’s QE tapering, global stock markets face central-bank tightening running $950b in 2018 and another $1450b in 2019 compared to 2017 levels! This will certainly strangle this QE-inflated monster stock bull. So on top of everything else this week’s sharp selloff portends, the euphoric stock markets were already in serious trouble from record extreme central-bank tightening. Got gold yet?

Absolutely essential in falling markets is cultivating excellent contrarian intelligence sources. That’s our specialty at Zeal. After decades studying the markets and trading, we really walk the contrarian walk. We buy low when few others will, so we can later sell high when few others can. While Wall Street will deny the coming stock-market bear all the way down, we will help you both understand it and prosper during it.

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The bottom line is the stock selling unleashed this week isn’t over. Given the fundamental, technical, and sentimental extremes around January’s record highs, a sub-10% pullback isn’t enough to eradicate the euphoria. At best a major correction approaching 20% is necessary, and those tend to run a few months or so. This week’s extreme VIX spike to levels that usually mark major bottoms was artificial, not normal.

And after such an extreme bull market largely driven by record central-bank easing, the odds really favor this selloff eventually growing into a 20%+ new bear. Especially with the major central banks starting to aggressively pull their liquidity in 2018. Whether a major bull correction or major new bear market, gold tends to thrive after major stock-market weakness. That leads investors to buy gold to re-diversify their portfolios.

Adam Hamilton, CPA

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