An interlude here in our assessment of the markets and valuation metrics from the last two days, because I’m concerned about the strange confluence of events taking place.

Let’s put together a broad picture:

• The VIX
• The 10-2s Yield Curve
• Dow Theory
• Money Supply

When I put these four things together, this is what I see right now:

• Too much money still in the economy (inflationary)
• Yield curve at historic spreads (recessionary)
• Dow Theory now bullish (not recessionary)
• VIX at ridiculous lows (complacency/greed)

Together we have mixed messaging and it tells me that traders and investors are ignoring or rejecting the possibility of a recession, fueling the near month-long rally in the major indexes.

That rally adds pressure to options selling tactics as the ‘fear’ of a market sell-off or correction has turned to massive greed chasing the indexes higher.

While we’re still getting results selling options on individual stocks, ETFs and indexes, we need some fear back in this market.

Let’s begin with the VIX – below is a weekly chart as it better captures the collapse in premiums in the options market.

The VIX has fallen by nearly 60% since the October 2022 highs, which indicates less hedging (buying of Puts or selling of Calls) and greater investor complacency. On the chart, however, the VIX has bottomed – sure, it could go lower, but I don’t think that’s likely.

Instead, in the weeks ahead, I see volatility coming back and pushing the VIX back toward 18-20 levels (that would represent a 30%+ rise from current levels).

BUT…I have a problem, which is Dow Theory, which turned BULLISH from BEARISH (a very significant change).

Below are DOW Industrials and Transport charts. In July, on a weekly chart, both indexes made a series of higher highs and higher lows, with the higher high rising above the October 2022 high.

The Industrials broke out of a sideways trend (June-July) with a strong move higher at the same time the Transports had built upward momentum.

So, now the indexes are fueling the ‘chase’ higher in the markets, which contributes to the lower VIX and disappearing premiums in the options market.

DOW JONES Transportation Index

DOW JONES Industrials

Against this sudden rise in optimism is an historic yield curve, which keeps running up against -100 basis points.

That’s the bond market screaming ‘recession imminent’ and the stock market saying “la la la … I can’t hear you.”

One of these is wrong. But, it’s getting harder to determine which one.

Which brings me to money supply (a chart I tend not to bring into discussion because it’s complex, but I’ll keep it simple here).

Money supply rising, as you can see from 2020-2022, is inflationary. (Big surprise, right?)

Money supply falling is recessionary. Money supply collapsing is deflationary.

The curve has sloped downward since the second-half of 2022, consistent with the slow decline in inflation pressure, but the total money supply is still too high.

That’s still too many dollars chasing too few goods, even though inflation has declined. When I look at home buying (down), retail sales (down), auto sales (down) … where is that money going?

Back into the stock market…

Some stupid observations, for fun and laughs:

I went to the grocery store last week to buy Kool-Aid for Liz (my wife).

$6.99 … for FLAVORED SUGAR.

The best value at the grocery store is pork.

No idea why, but it’s less expensive than chicken or beef (and don’t even bother with fish). I just bought an 8lb pork shoulder for bbq pork at $2.99/lb, versus two (2!) chicken breasts (1lb) at $3.99/lb.

What All of This Means

A recession – if, when – will occur bottom up in this economy. Because it will occur bottom up, that also tells me it should take longer to happen.

Investors and traders are betting that it won’t happen and that’s pushing indexes to levels we can’t justify based on actual earnings expectations. If earnings were to suddenly spike from increased sales/revenue, that would justify.

But that’s not happening right now.

I can’t stress enough the need for you to protect yourself in the months ahead. If Wall Street is wrong on the recession expectations, we’re going to see a very rapid correction.

Of course, that also means a huge spike in the VIX, which increases premiums for sold options, which makes selling options more profitable.

Which is what makes this weirder and weirder – which do you hope for? A market rally that continues upward but keeps premiums depressed, or, a correction which restores premium values but…yeah, recession.

If you feel like you don’t understand why the market’s going up when the ‘country’ seems to feel things are going badly, you now know you aren’t alone.

Tomorrow, I’ll explore some hedging tactics with options on the debit side.

John Hutchinson
Traders Reserve