Why There Could Be More “Black Fridays” In Our Future

I read a lot of research every week… But let me tell you, I am rarely surprised.

That’s not because I know EVERYTHING. (Wouldn’t that be nice?) No, it’s because Wall Street research teams tend to play it safe. A consensus opinion develops, and then analysts will release report after report highlighting that general theme.

For example, “stocks are overvalued” is a popular theme — and has been since the late 1990s. No one will ever lose their job suggesting that stocks are overvalued.

Occasionally, a research piece explores new ground. That was the case with a recent report from Goldman Sachs showing that liquidity decreases as volatility rises.

Source: Wellington Management

That chart uses the average size of the bids and offers in the S&P 500 futures market as a measure of liquidity. That’s shown in the vertical axis of the chart. The x-axis is the VIX level.

S&P 500 futures are a convenient way for large funds and firms like Goldman to gain exposure to the stock market. This has always been a large market, as the y-axis of the chart shows. When volatility is low, trades of more than $40 million can be executed easily. As volatility rises, liquidity can fall to less than $1 million.

The chart also includes two regressions fit to the data. The upper line (blue) compares liquidity to volatility from 2010 to 2015. The lower line (orange) fits the data from 2016 to 2021. The curves show that liquidity has been declining at all levels of volatility in recent years.

Other data shows that recent average liquidity is about one-third of its average 10 years ago. That confirms the picture shown in the chart above and helps explain what we should expect in a market selloff.

What This Means For Us

If liquidity disappears as prices fall, then a price decline could accelerate quickly. That was one of the factors that drove the steep decline in October 1987. Trading volume rose so quickly that some firms just couldn’t keep up. In other cases, market makers just didn’t have enough liquidity to keep trading. There were even reports of floor traders becoming paralyzed by fear and not trading because they simply didn’t know what to do.

A repeat of that is possible, and liquidity indicates that we need to be aware of that.

For now, there are risks, but there are also potential rewards for those who remain bullish. My Income Trader Volatility (ITV) indicator turned bullish last week as the SPDR S&P 500 ETF (NYSE: SPY) moved toward my price target of $440.

ITV (red line) crossed below its moving average (blue line). ITV is similar to VIX in that it rises as prices fall. Its current position, just below the MA, points to potential strength in stocks.

Our last chart this week shows my Profit Amplifier Momentum (PAM), which continues to point toward a possible rally.

PAM is designed as a short-term indicator. The red bars are bearish, and the green bars are bullish. Its recent bullish crossover is a potential indicator of strength.

Action To Take

My outlook is unchanged this week. I continue to expect a sharp rally followed by a bear market. But the main thing I want you to take away is this…

We can’t wait for the decline to act. As risks rise, it could be prudent to de-risk our portfolios.

One way we could do that is a way that I haven’t talked about much lately. And that’s by adding exposure to longer-term put options in our portfolio. Doing it now rather than later could even be prudent. As the chart above indicates, puts might be difficult to buy when volatility does rise, and experience tells us that puts will be expensive when prices decline.

That’s where my colleague Jim Pearce has you covered. He’s been predicting a “day of reckoning” for some over-hyped names (particularly in the tech sector) for a few weeks now. And he’s already begun to profit…

With Jim’s “mayhem” strategy, you don’t have to worry about overleveraging yourself when betting against these stocks. And you can still profit big-time when they begin to pay off.

Want to learn more? Go here now to check out his brand-new report.