We’re seeing more and more market experts expressing their concern over an impending market collapse. Ray Dalio, Founder of Bridgewater Associates, believes we’re in the final stages of the current debt cycle which will end in something similar to a 1930’s style recession. PIMCO portfolio managers sing the same tune predicting a high probability of a recession by 2020.
U.S. interest rate policy and the deterioration in US-China trade relations have been the main catalysts in setting off the most recent bout of volatility. In October, The Dow Jones Industrial Average (“DJI”), S&P500 and NASDAQ all fell approximately 6%, 6% and 8% from their respective highs, while market volatility, an indicator of market sentiment, at one point spiked over 200%.
These market hiccups typically bring about predictions of an impending market meltdown but what often happens is a bounce back to previous highs. This has led to the strategy known as “buying the dip”. There are only so many times that investors can call the market’s bluff, the question is will this recent bout of volatility bring about the sell off that portfolio managers have been expecting?
Earlier this past February, we saw major US market indexes fall roughly 12% and a corresponding multi-year high in the Volatility index of approximately 50. If we were to use the VIX as a gauge of how deep of a market sell off we’re to expect (investor sentiment), then the recent high of 28 should equate to an estimated 6% fall in US market indexes which is what actually transpired, as both the DJI and S&P500 are trading roughly 6% below their previous peak.
However, there is no guarantee that volatility is over as Google search trend data has hinted. To get a sense of why Google Trends is being used to gauge investor sentiment, there is a really interesting research paper which identified a relationship between the rise in searches for the term “debt” and notable sell offs in the market. We took this a step further and looked at searches for a series of financial news outlets and compared this against the Volatility Index (“VIX”). To our surprise, we found a close relationship between searches for financial news outlets and movement in the VIX index where a rise in searches coincides with a rise in volatility and thus a market selloff. While we’re not suggesting to replace the VIX with search data, it can be an interesting data point especially where Google Trends and the VIX starts to diverge.
The points circled in red are the spikes in searches in February and October 2018. The February search spike coincided with a 12% market sell off from peak to trough and a VIX high of 50. The search spike in October 2018 reached February levels however markets only sold off 6% and the VIX rose to 28 or about half of February levels. We infer from this that negative market sentiment, by way of nominal searches, is proportionately similar to what we saw in February, however, markets have not fully priced this in. This observation leads us to believe that markets could remain at current levels for an extended period of time or we’re on our way to a bottom that sits approximately 6% lower from where we currently stand.
Nominal searches for our specially crafted financial news search indicator currently stands far below what was reached in 2008 but what is of real concern is the upward trend in searches that started in the beginning of 2018. We saw a similar build up in 2007 right before the market crash and should be treated as a warning sign that sentiment is getting progressively negative and where subsequent episodes of volatility may be sharper and lead to more pain in the markets.