If there’s one thing that shows the massive disconnect between stock market performance and economic activity, it's a chart of the Institute of Supply Management’s Report on Business: one of the world’s most popular economic sentiment indicators and the S&P500 index.
The disconnect is a result of several interventionist policies from major financial institutions and the White House: the multi-billion dollar liquidity injections, the buy-side algorithms, the ability for companies to buy back their own shares, and the slashing of interest rates on a downward path to zero. As a result, stock markets are climbing in a bizarre, linear fashion reminiscent of the time before the early 2018 correction.
Because of interventionism within the financial system and how it shaped the market environment over the last decade, it's rational to think that stocks will continue to rise. But for anyone who makes their investment decisions based on fundamentals, they now have to overcome a tricky dilemma: how do you commit to investing in the stock market when you know, for a fact, that economic fundamentals are failing to portray a similar narrative?
The struggle to decide whether to invest doesn’t stop there, though, as resisting the urge to take part creates the fear of missing out — or FOMO for short. If the market mania and hysteria persist for a long period of time while fundamentals continue to deteriorate, you’ll have to be comfortable knowing you’re missing out on future gains before an inevitable stock market correction.
On the other hand, deciding to participate means dealing with yet another obstacle. As the fun began in September 2019 when the Fed launched its silent quantitative easing program, it’s been a solid five months of parabolic stock market action. So what if we’re already late to the party?
One way to find out is by following investor sentiment indicators which give us a good idea of whether we are throwing our money away and paying a cheque to the market. Right now, sentiment shows we’re doing just that: CNN’s Fear & Greed Index — a combination of seven popular indicators: stock price momentum, stock price strength, junk bond demand, put and call options ratios, safe-haven demand, and market volatility — has risen to the highest level since Winter 2017.
The current market sentiment reflects one of Warren Buffet’s famous quotes: “Be fearful when others are greedy,” illustrating how extreme greed is a reliable indicator of an overconfident market — a logical time to trade out of winners whose stock prices have risen dramatically despite weakening earnings growth and other major fundamental drivers.
Another indicator that sides with Buffett’s theory is the VIX (CBOE Volatility Index), also known as the Fear Index, which measures daily market volatility.
Presently, the VIX is on a path towards the notorious “Volpocalypse” level of February 5th, 2018 when the index exploded 200% higher and the market sold off at least 10% from its high. When the indicator reaches such a low level it indicates extreme optimism: the belief that nothing will stop markets from climbing higher which, in reality, is never the case — there’s always a correction.
For the many investors who’ve woken up to this mind-boggling disparity, the abundance of uncertainty it creates means 2020 will be a year of wait and see; a year of sitting on the sidelines anticipating what happens next in the strangest market environment of our time.
On the flip side, for anyone who’s brave enough to participate in the current market mania, the days of valuing stocks based on company fundamentals are over. Instead, in 2020, your new role as a trader, investor or speculator is assessing the reliability of the market’s plumbing, and predicting how long before a blockage in the financial system causes a volatility explosion once again — an almost impossible task to achieve.