Bull Markets Die on Euphoria
The comments below are an edited and abridged synopsis of an article by Jesse Felder
Felder has written about major breadth warnings in the stock market, deteriorating fundamental conditions and how investors were not embracing risk in ways that would be supportive of sustained gains. In this article, he shares a longer-term perspective that highlights how important these long-term divergences can be.
A chart in the article plots the S&P 500 along with a simple measure of equity market risk appetites, volatility and corporate bond spreads. Normally, all of these things should move in sync. As stock prices move higher, they should be supported by rising risk appetites, falling volatility and falling corporate spreads. When these indicators diverge, it can be an early warning sign that the environment is changing, and prices are about to reverse.
At the March 2000 price peak in the S&P 500, though this measure of equity market risk appetite didn’t diverge from prices, both volatility and spreads did. At the 2007 price peak, all three were flashing this warning signal. They did it again in 2015 before the August flash crash and the plunge in stock prices in early 2016. Once again, all three of these indicators are diverging from prices, suggesting something may be changing in the investing environment, and that investors should be cautious.
Sir John Templeton famously said, “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”
These indicators of risk appetites across the equity, options, and fixed income space help to visualize that point in time when optimism and euphoria are exhausted, and the trapdoor to lower stock prices is opened by a major shift back towards risk aversion. This may be another one of those times.