The SP500 is a bubble and the general consensus view is there is more upside to come but there are warning signs of a possible correction to the downside. In this article we will look at the sentiment and technical levels to watch out for but first a very good quote from legendary trader George Soros:
“My interpretation of financial markets differs from the prevailing paradigm in many ways. I emphasize the role of misunderstandings and misconceptions in shaping the course of history. And I treat bubbles as largely unpredictable. The direction and its eventual reversal are predictable; the magnitude and direction of the various phases is not. ” (George Soros)
Bubbles can run on further than the majority expect and if we look back at the tech bubble of the 1990s many were calling for a correction a year or before it occurred. At present we don’t have many forecasters seeing a correction in stocks but that is very often when they occur.
The market should go up according to the majority due to central banks flooding the financial system with liquidity, the global economy is going to recover to hit growth rates higher than before the pandemic and if the stock market falls, the Fed will come into support it.
The problem is central bank stimulus will decline from here, the view of a strong recovery in the global economy is discounted and the Fed may not be able to stop a severe correction due to the huge buying especially by retail traders.
To See how bullish the market especially retail traders we can look at call option buying. A call option is bought on the view the market will rise (a put is bought on the view the market will fall) the call option buying is way more than in the tech stock bubble peak and can clearly be seen on the charts below:
The small inexperienced retail trader is seeing no dangers ahead (as in all bubbles and mania’s) and the recent dip in the SP saw an increase in option buying. There have been record inflows into global equities over the last 3 months. Both US and European equity inflows are at record highs and against these volumes, the price rise we have seen is small in percentage terms if these volumes slow that will obviously weigh on price.
The retail traders are taking big risks but so to are global fund managers with risk-taking at an all-time high:
In terms of the technical picture we have a very bullish chart but on the recent breakout to new multi-year highs, we have seen small candles so this could indicate volumes dropping. A move through second level support back through the previous breakout level could be a warning of a correction coming and for traders who are long this in our view is a good level to look at to have stops behind and for traders who want to take a contrary short trade.
Conclusion
Bubbles or mania’s as we noted earlier take time to end but the level of buying and risk-taking is now at an extreme. Traders are forgetting about value with many just buying due to the fear of missing out or there are no downside risks. “This time is different” is the argument given by the majority during every mania as traditional valuation measures are seen as outdated.
In Charles Mackay’s book Extra Ordinary Popular Delusions and Madness of Crowds an early study in crowd psychology published in 1841 he noted that in all bubbles and mania’s: “Men, it has been well said, think in herds; they also go mad in herds, while they only recover their senses more slowly, and one by one.” (Charles Mackay) This bubble is no different from the ones Mackay covered in his book – human nature and psychology never change.
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