“Are markets going to crash?” is likely moving up the ranks of the most Googled searches lately. Markets continue to be mired in extreme levels of volatility, and we’re on pace for the worst year since 2008. Everyone wants to know whether we are at the bottom or if there’s significantly more pain to come. There is no way to know for sure, but there are typically a few signs that indicate when we are getting closer to a bottom.
As mentioned in a prior commentary, while this time does feel a bit different, markets will eventually bottom and experience a breathtaking rally. The issue is I can’t tell you with any accuracy when that will be! Markets can be very frustrating and, at times, downright ruthless. To “win,” you need to exhibit patience and remain calm, which is easier said than done!
Let’s take a look at a few indicators that may help shed light on how close we are to a market bottom.
VIX
The Volatility Index (VIX) is a good barometer to keep an eye on. The index measures the stock market’s expectation of volatility. When panic or fear grips markets, the VIX tends to spike since people are buying “protection” against further market volatility.
While there is no “silver lining” answer, history shows that when the VIX reaches 40, it means a bottom is near because fear and panic have reached their highs. Now, there are a few outliers—such as the 2008 Great Financial Crisis and the 2020 COVID crash in March—but this rule gives us a baseline to work off.
As of this writing, VIX is just shy of 30. While 30 is higher than its average, there could still be some room for it to increase before finding a bottom.
At a certain point, the sellers will exhaust themselves, and buying will pick up. This usually happens when VIX experiences a massive spike over a few days. Keep in mind that markets tend to bottom when things look their worst.
Risk Premium
One area I pay a lot of attention to involves the “yield premium” in bonds. When the interest rates on high-yield junk bonds (higher risk) surge significantly above U.S. treasuries (lower risk), that is generally a sign of maximum pain and that markets have priced in extreme negativity.
As a rule of thumb, when the yield premium on high-grade corporate bonds rises above 2.50% versus Treasury yields, and 8% on high-yield fixed income, that usually indicates far too much pessimism has been baked into the economy.
This barometer hasn’t experienced a massive spike and still remains relatively low from a historical perspective.
Investor Sentiment
Oftentimes, investor sentiment can help give us an idea of how close we are to a bottom. The American Association of Individual Investors (AAII) publishes a weekly report illustrating where investors think markets are headed in the next six months. The responses can be “bullish,” “neutral,” or “bearish.”
Source: Ally.
Currently, bearish sentiment is approaching a 35-year high! This means investors expect stocks to be lower six months from today. I know you’re thinking, what kind of insight can this actually provide? Well, when investors get extremely negative and throw in the towel, that’s generally when markets start to bottom.
Put Call Ratio
The options market can help give us some insight as well. When the number of put options (bets that the market will decline) exceeds call options (bets that the market will rise), bearish sentiment has taken hold. In the options world, this means investors expect markets to drop further from current levels. This can be used as a contrarian indicator because the bottom is typically near when sentiment gets too negative.
This ratio reached a high of 1.7 in late 2018 (China Trade War) and 1.8 in 2020 (COVID). It hit a peak of ~1.35 this year, indicating that investors aren’t in all-out panic mode yet.
Final Thoughts
Do any of these indicators alone tell us anything definitive? Absolutely not, but collectively they can help gauge when we are getting closer to a bottom. Markets are likely to test your patience in the coming weeks and months. Just remember to focus on what you can control, and don’t lose sight of your financial plan!
Discuss your situation with a fee-only financial advisor.
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