Stock traders have grown increasingly bullish and complacent—and that’s a bearish signal.
A fresh concern on the stock market’s horizon is the new all-time high of the CBOE’s SKEW Index. While many analysts interpret this rise as a sign that traders believe a Black Swan event, such as a crash, is now more likely, this view misreads the implications of the SKEW Index.
If this were true, it would suggest that Wall Street’s irrational exuberance is waning, which would be a positive development for contrarian investors.
In reality, the new high in the SKEW Index signals the opposite—it means traders have grown even more bullish than before, which is a bearish sign from a contrarian perspective.
To understand why, let’s look at how the SKEW Index is calculated. Although the math is complex, the index essentially measures the gap between the consensus view of most traders and the outlook of a small, super-bearish minority. When this gap widens, the SKEW index rises.
There are two ways this gap can grow. The first is when the super-bearish minority becomes even more bearish, while the consensus view of most traders stays the same. This is the interpretation most commentators suggest, claiming that the rise in SKEW indicates increasing worry about a market crash.
The second, less recognized way for the SKEW to rise is when the bearish minority remains steady, but the majority of traders grow even more bullish. In this case, a higher SKEW doesn’t reflect increased concern about a crash, but rather a diminishing sense of worry among the majority of traders.
The implications of these two scenarios are very different for investors.
There are two key reasons why the SKEW’s new high actually indicates less concern about a market crash.
First, the Yale University “U.S. Crash Confidence Index,” conducted by Robert Shiller, shows that individual investors are now less concerned about a crash than at any time in the last 15 years. It seems contradictory for the SKEW Index to signal heightened crash concerns while Shiller’s data shows the opposite.
Second, the SKEW index has historically risen in tandem with bull markets. As the market climbs, the consensus view among traders becomes more bullish, widening the gap between the majority’s expectations and the views of the bearish minority. This relationship between bull markets and a rising SKEW index is backed by a strong 56.3% correlation over the last 15 years, showing that the SKEW index typically increases during periods of market growth.
In conclusion, despite some claims, Wall Street is not concerned about a market crash. And that should be a cause for concern.
