"The collapse of major bubbles is often preceded by the collapse of smaller bubbles representing ‘fringe’ speculations. Those early wipeouts are canaries in the coalmine. Once investor preferences shift from speculation toward risk-aversion, extreme valuations should not be ignored, and can suddenly matter to their full extent.

A month ago, I noted that prevailing valuation extremes implied negative total returns for the S&P 500 on 10-12 year horizon, and losses on the order of two-thirds of the market’s value over the completion of the current market cycle. With our measures of market internals constructive, on balance, we had maintained a rather neutral near-term outlook for months, despite the most extreme “overvalued, overbought, overbullish” syndromes in U.S. history. Still, I noted, “I believe that it’s essential to carry a significant safety net at present, and I’m also partial to tail-risk hedges that kick-in automatically as the market declines, rather than requiring the execution of sell orders. My impression is that the first leg down will be extremely steep, and that a subsequent bounce will encourage investors to believe the worst is over.”

On February 2nd, our measures of market internals clearly deteriorated, shifting market conditions to a combination of extreme valuations and unfavorable market internals, coming off of the most extremely overextended conditions we’ve ever observed in the historical data. At present, I view the market as a “broken parabola” – much the same as we observed for the Nikkei in 1990, the Nasdaq in 2000, or for those wishing a more recent example, Bitcoin since January.

Two features of the initial break from speculative bubbles are worth noting. First, the collapse of major bubbles is often preceded by the collapse of smaller bubbles representing “fringe” speculations. Those early wipeouts are canaries in the coalmine. For example, in July 2000, the Wall Street Journal ran an article titled (in the print version) “What were we THINKING?” – reflecting on the “arrogance, greed, and optimism” that had already been followed by the collapse of dot-com stocks. My favorite line: “Now we know better. Why didn’t they see it coming?” Unfortunately, that article was published at a point where the Nasdaq still had an 80% loss (not a typo) ahead of it.

Similarly, in July 2007, two Bear Stearns hedge funds heavily invested in sub-prime loans suddenly became nearly worthless. Yet that was nearly three months before the S&P 500 peaked in October, followed by a collapse that would take it down by more than 55%.

Observing the sudden collapses of fringe bubbles today, including inverse volatility funds and Bitcoin, my impression is that we’re actually seeing the early signs of risk-aversion and selectivity among investors. The speculation in Bitcoin, despite issues of scalability and breathtaking inefficiency, was striking enough. But the willingness of investors to short market volatility even at 9% was mathematically disturbing.

See, volatility is measured by the “standard deviation” of returns, which describes the spread of a bell curve, and can never become negative. Moreover, standard deviation is annualized by multiplying by the square root of time. An annual volatility of 9% implies a daily volatilty of about 0.6%, which is like saying that a 2% market decline should occur in fewer than 1 in 2000 trading sessions, when in fact they’ve historically occurred more often than 1 in 50. The spectacle of investors eagerly shorting a volatility index (VIX) of 9, in expectation that it would go lower, wasn’t just a sideshow in some esoteric security. It was the sign of a market that had come to believe that stock prices could do nothing but advance in an upward parabolic trend, with virtually no risk of loss.