Why “never sell short in a lackluster market” is great stock advice
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As the old sayings of traders say, history shows that “never bypass a dull market” is great advice. But there is always room to be cautious with the S&P 500 index trading in “thin air,” according to a well-known Wall Street researcher.
When the Cboe volatility index “trades consistently below 20, the S&P has performed well and has not suffered any annual declines,” wrote Nicholas Colas, co-founder of DataTrek Research, in a Tuesday note. .
The VIX, an options-based measure of the S&P 500’s expected volatility over the next 30 days, was trading at 16.79 on Tuesday and has not traded above 20 since May 24.
Meanwhile, the stock market has been fairly sleepy, trading largely sideways over the past two months, albeit with the Dow Jones Industrial Average and S&P 500 near all-time highs.
The adage seems particularly apt, Colas wrote, “because we see the S&P 500 moving closer and closer to new highs with few tradable / shorted pullbacks. It seems somewhat surprising, given all the chatter about inflation, downsizing, etc.
So what does history show? Colas pointed out the chart below tracing the VIX to the early 1990s and labeling markets when the VIX was consistently below 20 as “boring” and those consistently above 20 as “exciting”:
And here’s how the S&P 500 did during the lean period, according to Colas:
- 1992 – 1996: + 15% compound annual total return with no years of decline (although 1994 – when the Fed started raising rates – was close, with only a total return of + 1.3%).
- 2004 – 2006: 10.3% of total annual compound return, also without years of decline.
- 2013 – 2017: + 15.6% annual compound total return, and no year down (we’re giving the August 2015 ETF flash crash a pass – that’s the peak you see in the chart about 3/4 of the way through the time series)
Colas acknowledged that the VIX spikes above the 40 level were also good buying opportunities, noting that DataTrek has a standing recommendation to start buying domestic stocks when the index breaks this level.
Meanwhile, there are legitimate questions as to whether the VIX has entered solidly into lackluster territory or simply reflects the “calm before the storm”.
“If you can create a story about a specific shock that’s imminent ready to go on stage, then it’s reasonable to sell here even if the tape is” dull, “Colas wrote.
The analyst described his view as “more cautious than purely bearish,” noting that history also shows that the S&P 500 rarely rebounds above 10% three years in a row. A 12.5% gain from the start of the year to Monday leaves the market in “somewhat rarefied” territory.
“We would like to see a ‘Dull Market 5% pullback’, even if it is not a short negotiable opportunity, to allocate capital at better levels,” said Colas.