Rally Resumed

In The Highstreet Group by John Bartoletta

Rally Resumed | Volatility Decreased | Complacency Increased (Update 3)

MARKET REACTION: We published two Blogs recently, one on February 24, 2017 titled “Election Rally Continues | Volatility Decreasing | Complacency Increasing” and the other on April 20, 2017 titled Rally Slows | Volatility Increasing | Complacency Waning (Update 2) which outlined our thoughts on the market as the new administration took over. At that time, the U.S. stock market indexes were setting new all-time highs, and with that came the usual “fear of missing out” as investors were throwing in the towel and buying some of the stocks that had already made substantial moves to the upside.

We suggested that this may not be the best strategy, as there were some areas of the market that have lagged the indexes in performance and may be better places to position for the future. We believed the current market (at that time) was within a very short-term rally within a longer-term uptrend, and we believed there will no doubt be mini corrections within the long-term bullish cycle, creating more attractive buying opportunities.

At the time of the second writing, the markets peaked and are entering a short-term sideways consolidation phase. Many investment markets continued to move along in some consolidating patterns.

CURRENTLY: The market indexes have rebounded slightly back to new highs but have been unusually quiet during the past several weeks, and quite often this kind of inaction can precede a more volatile period, but given the market’s resilience in this period of high uncertainty, it’s hard to imagine what kind of catalyst would cause the market to move.

Indexes have been trading in some rather tight ranges over the past two months with the DJIA and S&P trading within 4% bands since February. The market and stocks do tend to cycle between periods of higher and lower volatility, enough so that when a more volatile period does arrive, it comes as a shock to investors who get settled in and used to the quieter periods. The current reads on the short-term indicators are also flat and not very helpful, in our opinion, as are the opinions out there that seem to be all over the place. We see the market as setting up for a possible pullback, as there are just too many stocks and groups that are already correcting, which makes it more difficult for a stronger rally period to develop. So we would not be surprised to see the broader markets pull back over the near term, and then grind away in a somewhat larger range over the summer in a traditional and normal pattern.

Stocks have been reacting to their earnings in a more dramatic fashion, however, with some notable beats being offset by other disappointments to give the individual stock components of the market a much more mixed indication for the market indexes. This lack of cohesiveness by many of the stock components of the market keeps us in a cautious position for the overall market going forward.

In a long-term bull market, it is normal for different sectors and styles of investing to outperform for various periods of time that can stretch into years. It is true that most stocks move higher during a bull market and that some of the cycles of over and underperforming sectors can last for months and years, making it important to recognize where in the trend the overall market is and which areas tend to do best during the evolving bull market. In general, a bull market that is early in its development tends to see the large-cap, lower-P/E, and higher-yielding stocks do best. As the bull market continues, the more-favorable sectors tend to shift to the growth areas and more-aggressive small-cap stocks as the economy and investor sentiment improve to more-robust levels. Although there are now many opinions being expressed about the relative age of the current bull market, many of the longer-term indicators are still far below the kinds of levels that suggest an end to the trend. We still see years ahead that could be very rewarding for investors who can tune out the short-term noise and focus on the longer-term trends that are still improving.

VOLATILITY (S&P P/E to VIX SPOT Ratio): Again with respect to our previous Blog mentioned in the beginning, we were cautious with respect to Higher P/E’s combined with Lower VIX. Our research into rising valuations and falling volatility suggested that a correction was coming or at least a pause. It is a very small move relative to the overall market performance recently, however the markets needed to pause or correct and volatility must increase in order to maintain healthy market balance. We feel this could happen again in the short-term.

The charts compares the price-to-earnings ratio for the Standard & Poor’s 500 Index with the 30 day average for the Chicago Board Options Exchange Volatility Index, or the VIX. As you can see in the updated charts, the markets have paused causing a slight reduction to the ratio and begun to rally with respect to complacency. This would suggest again that the market is ahead of itself showing signs of overvaluation. The markets paused slightly, corrected and rallied again, making stocks fundamentally less attractive. This balance of people chasing (demand) combined with a short-term pause could be strong enough to lessen any corrective move of 5% or more at this time.

VOLATILITY (VIX): Volatility, as measured by the VIX, is a statistical measure of the dispersion of returns for the S&P 500 index. This index is the standardized barometer for volatility used by most institutional and private investors worldwide. The extreme low level of risk combined with increased complacency was not sustainable and the probability of corrective move increased. Investors began hedging their portfolios causing a rise in the VIX as we suggested.

The chart above is the most compelling of the charts shown in this blog. It represents an overlay of the S&P 500 Index and the spread of the VIX spot (current) price minus the VIX 3 month futures price (as represented by the green and red shaded areas on the chart). Previously, it showed the VIX term structure known as “contango”. The term structure when combined with the other volatility indicators can represent a near-term reversal (correction) in the equity markets. What’s compelling is that when these series of indicators show a discount (shown in red), a short-term reflex sell-off ensued. We believed that, given the data shown above, the probability of a V-shaped reversal was possible. What is currently at play is a pause and a slight correction. We will be watching this closely.

With the previous strong upward action (shown above) in the equity markets and the fact that the markets were continually making technical new highs, the VIX (volatility Index) dropped to levels that correspond to our previous writing. These levels are showing signs that the market rally could be slowing down and that a possible short-term correction could ensue. We were buying volatility here to protect current positions within the portfolios and the positioning worked.

Currently, the VIX has decreased dramatically, corresponding to the slight rally in the markets. The VIX decrease has slowed. We will be looking for a possible market pullback and an increase in the VIX which would correspond to further downside pressure in the markets.

SHORT-TERM (Days to Weeks): Toppy. We believe that the stock market indexes are in a cyclical bull market within a long-term secular bull market, but are extended and have correction risk for the short term. We believe there are many indications that the strong uptrend of the past year is losing some of its momentum, and with the S&P off about 1% from its peak, and approaching its 50 day moving average, we see the risk for another 5%–10% of possible risk in the weeks ahead. Most stocks and groups may have similar risk to the averages, however those areas that have above-average risk could be the ones that have made the biggest moves to the upside since November, and also those that are already in clearly declining trends. But otherwise, this appears to us to be a good time to hold and focus on yield and watch for better buying opportunities after some stocks pull back.

INTERMEDIATE-TERM (Weeks to Months): Neutral. The S&P 500 and the Dow Jones Industrials have had a remarkably strong move over the past 12 months. We suspect the strength will lead to a period of consolidation in about a 10% range that could hold the market for the next few months as stock fundamentals and the economic measures catch up to the higher levels of the stock market.

LONG-TERM (Months to Years): Bullish. The Dow Industrials and the S&P have been in bull markets since 2009, and they continue to trade in rising channels that imply further gains over possibly many more years. We continue to believe the U.S. stock market is about a third of the way into a longer-term secular bull market that we expect to rise until the sentiment of investors and the public becomes much more optimistic about the future, which could still take many more years to develop. The theme of this bull market has been that of changing group rotation where different market sectors and groups do better or worse at various times, and we suspect this kind of cyclical rotation between stock groups will likely continue as the bull market evolves. It is usually not until much later in the long-term cycle when the market gets to a position where most groups and stocks are in bullish trends, so we believe a long-term holder of a diversified portfolio can expect to see this varied performance between different stock groups continue for several more years.

TRADING UPDATE: We have been putting a limited amount of cash to work into stocks as conditions warrant. We have been rebalancing portions of the portfolios while slightly changing the overall cash weighting in the accounts. The remaining cash can be put to work quickly should we see opportunities present themselves and the potential for hedge positions will remain a trading tool to improve risk exposure in the portfolios. When this pause or corrective period runs its course and/or the markets tell us that they want to move higher based on our research, we will begin the process of getting back into the markets and get fully invested. Until then we remain diligent in our research and will continually monitor the markets and report back at the quarter end.