That was the robot’s warning in the sixties TV show, Lost In Space. That may be too old a reference for some of you, but that sentiment is my message. The Standard and Poors 500 index (SPX) closed down five points at 4505, in stark contrast to this week’s gain of over 2.5%. Three of the morning market openings this week were gap openings higher, and dramatically so on Wednesday and Thursday. Today’s market started higher but could not hold the new high and closed lower on the day. Trading volume ran below the 50-day moving average (dma) all week.

VIX, the volatility index for the S&P 500 options, opened the week at 16.1% and steadily declined all week, closing today at 13.3%. VIX spiked just over 17% last Thursday but continued its decline into this week.

I track the Russell 2000 index with the IWM ETF and IWM started the week strongly higher but slowed starting on Wednesday and continuing through today. IWM closed at 192, down two points or down one percent, but still maintained a weekly gain of 3.8%. We expect the small cap stocks of the Russell 2000 to lead both bull and bear markets, but they remain well below the February highs.

The NASDAQ Composite index closed at 14,114 today, down 25 points or -0.2% but NASDAQ had a very bullish week, up 3.4%. NASDAQ’s trading volume ran at or above average all week.

I follow the CBOE SKEW Index chart along with several others to monitor the overall state of the market, e.g., NYSE New Highs – New Lows, the CBOE Put/Call Ratio, etc. SKEW compares the implied volatility of ITM options versus the implied volatility of OTM options. If the implied volatility is rising for OTM puts, that implies increased demand and may suggest increasing probability of a black swan event, i.e., a large correction or market crash. The SKEW index over the past three years shows a couple of peaks during 2021 as the bear market developed. By the end of 2022, we had reached a minimum in the SKEW index. But now SKEW is rather high, over 150 in early June and closing today around 148.

The FOMC and central banks around the globe reduced interest rates to historically record levels to avoid a recession caused by the pandemic. Many banks and individuals purchased low interest treasury bonds to at least generate some measure of income. When interest rates rise, the prices of bonds decline to keep the effective yield of the bonds at market levels. If the average market rate is 6%, you would not pay the nominal value of $1000 for a treasury bond; the market will discount that bond to a level where the bond’s posted two percent rate yields a rate of return consistent with current levels of interest.

Individuals build bond ladders with a portfolio of bonds with different interest rates and maturities. When rates rise, one or more of those groups of bonds decline in price, reducing the value of the bond portfolio. When a particular group of bonds (a rung on the bond ladder) matures, the investor receives the full nominal value of the bond ($1,000) and replaces that portion of the bond portfolio with new bonds bearing the current market interest rate.

What happens when a bank holds billions of dollars of 2% treasury bonds? The bank’s balance sheet declines significantly due to the declining value of those bank assets. The bank may then be in danger of not being able to fulfill the requests of depositors for a portion of their funds. Rumors fly and this results in a run on the bank; the bank closes and the federal bank examiners take over. In most cases, FDIC insurance reimburses the depositors, but that is limited to $250,000 per account. The first bank to close was Silicon Valley Bank; their depositors were not middle-class Americans; many were Silicon Valley venture capitalists with multi-million dollar accounts. As you might expect, those depositors had political clout and new Federal rules were quickly created to make them whole. The next group of banks that were in danger of failing were saved in a different manner. Treasury officials found a larger bank and convinced it to buy the smaller bank to keep it financially “whole”. It isn’t clear if more banks will follow. It is a scary scenario.

I tell you this long story to illustrate the underlying problem. The fundamental mandates of the Federal Open Markets Committee (FOMC) are to maintain steady economic growth, prevent economic recession and control inflation. Their two main tools are buying and selling treasury bonds to control the money supply and establishing the federal discount rate, the interest rate charged by the Federal Reserve to member banks. That rate is marked up as it filters down through the banks to businesses and individuals.

As inflation heated up over the past two years, the FOMC began to raise interest rates to slow down inflation and return the inflation rate to the federal target rate of 2%. Those rising rates have put the banks holding 2% treasury bonds in a tight spot. The FOMC is also in a tight spot. Should they continue to raise rates in order to bring down inflation at the expense of some banks failing and possibly risk pushing the economy into a severe recession? I am sure Powell is receiving a lot of political pressure to back off on the rate hikes.

Now you see why the SKEW index may be at such high levels. The risk of a recession is increasing, and traders are buying OTM puts for protection. We have seen the failure of several reasonably large banks. Are more failures on the horizon?

In light of this background, I find the recent bullish stock market strength we have witnessed to be very surprising. The weak trading volume we have observed all year shows a lack of conviction by the bulls. A lot of capital remains on the sidelines. The hesitancy of the Russell 2000 to join in the rally is another bearish sign. Those small to mid-cap stocks normally lead bull markets.

I am even more cautious now. I am not a day trader, but the day trader is always fully in cash at the end of each day of trading and that appears very attractive to me right now. Be careful out there.