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Dow Futures Rise But There’s a Massive Volatility Shock Coming

Last Updated September 23, 2020 1:57 PM
Ben Brown
Last Updated September 23, 2020 1:57 PM
  • Dow Jones Industrial Average (DJIA) futures tick higher after yesterday’s selloff.
  • Extreme pent-up volatility is waiting to explode after weeks of relative calm on the market.
  • JP Morgan analysts still maintain we won’t go back below the March low.

Is this the calm before the storm? After weeks of sideways ranging, volatility is creeping back into the stock market this week. 4% higher on Monday, 1.6% lower on Tuesday. Now, Dow Jones Industrial Average (DJIA) futures are up another 1% this morning. Something is brewing.

Stock market volatility has eased off since the March panic, but a massive shock lies in wait if you look below the surface . Matt Forester at BNY Mellon’s Lockwood Advisors confirmed as much:

More volatility than what we’ve seen over the past couple months is probably in order for the market.

stock market volatility building
Small traders are historically optimistic right now with bullish bets at a record high. This a recipe for another extreme move higher or lower. Source: Bloomberg / Sentimentrader

Dow futures shrug off Tuesday’s losses

The stock market ended Tuesday’s session with a painful slide as health experts poured cold water on the Moderna vaccine trial hype. Despite the selloff, Dow futures  bounced back overnight, currently charging 224 points (0.9%) higher.

Dow Jones DJIA stock market futures
Dow Jones Industrial Average shrugged off yesterdays losses and turned higher overnight. Source: Yahoo Finance

S&P 500 futures  and Nasdaq Composite futures  were up 1% each.

Brace for epic stock market volatility

The Dow has been stuck in a sideways range for almost six weeks. That’s a lot of pent-up volatility waiting to explode. If there’s one thing we know about sideways ranges, it’s that they eventually break higher or lower – usually with fireworks.

The only question is: which way will it go?

Dow range
The Dow has been trading in a tight sideways range for weeks. Time for a breakout. Source: TradingView

It all comes down to an epic battle between small retail investors and the high-net worth investor class. Here’s how it breaks down.

Retail investors are historically (naively?) bullish

The data for small retail investors is off the charts. Monday was the biggest buying spree in New York Stock Exchange history.

stock market buying record
NYSE saw record buying on Monday this week. Source: Bloomberg

That’s not all. The number of net bullish options contracts opened by small traders just hit historic highs. And the CBOE put/call ratio confirms the sentiment, too. Traders are now as bullish as they were at February’s all-time highs.

put call ratio
The put/call ratio is back to February lows, indicating that traders are overwhelmingly bullish. Source: Bloomberg

This is pent-up volatility waiting to snap. But it’s is a phenomenon that makes Sundial president Jason Goepfert nervous:

There is no data we follow that is more worrying than this.

He explains that retail investors are a contrarian indicator. They are typically wrong at the extreme emotional ends of the market, he says. It could indicate that volatility could explode downwards, catching the retail crowd off guard.

Established investors are historically bearish on the Dow Jones

The other side of this pent-up volatility is the wealthy, high-net worth class. They’re all on the sidelines. Every major sentiment survey (Bank of America, Deutsche Bank, AAII) shows peak pessimism among traditional investors.

Legends like Buffett, Tepper, and Druckenmiller are all the sidelines. More than $4 trillion is parked in money market funds. This is what extreme caution looks like.

This might be the biggest divergence in investor sentiment in modern history. Retail is historically bullish, institutions are historically bearish. This divergence has to resolve and snap one way or the other. And it could happen soon.

JP Morgan: we won’t got back to March lows

JP Morgan’s chair of global research, Joyce Chang, is firmly in the cautious camp. Speaking to CNBC, she said the market needs to consolidate after such a rapid rally. But she doesn’t see it breaking down past the March 23rd lows .

I don’t see us going back to March lows because I really do think the Fed has put a floor on this.

Unprecedented stimulus from the Federal Reserve and forthcoming fiscal support, she claims, will act as a backstop if there is another retrace.

What will it take for a full Dow Jones recovery?

If this stock market rally is just a retail-fuelled phenomenon, what do we need to see before a real rally occurs? According to Sean Stannard Stockton at Ensemble Capital, he’d like to see small cap stocks catch up to the big names .

I do think it’s very notable that the biggest companies – the ones with the best balance sheets and credit ratings have recovered the most.

True bull markets typically kick in when money broadens out across the whole market – not just a handful of blue-chips. If we see that happen, Stockton says he’d be more convinced about a recovery.