Stalled Rally | Bottoming Volatility | Complacency at All-Time Highs (Update)
MARKET REACTION: We published Blogs over the past several months, one on February 24, 2017 titled “Election Rally Continues | Volatility Decreasing | Complacency Increasing”, another on April 20 titled “Rally Slows | Volatility Increasing | Complacency Waning” and more recently, on May 17 Blog titled “Rally Resumed | Volatility Decreased | Complacency Increased”. All have had a recurring theme of markets bouncing around their near-term highs. For all the press about markets hitting all-time highs, the S&P and Dow are only 2% higher than where they were at the end of February. From every dip in the market has come the usual “fear of missing out” as investors buy the slightest drop. Conversely, investors have also been selling rallies, thus leading to a stagnant market over the past 4 months.
As mentioned in prior blogs, we believe the market is in a short-term sideways consolidation phase within a longer-term uptrend, and we continue to believe that there will be pullbacks and small corrections within the long-term bullish cycle, creating more attractive buying opportunities.
CURRENTLY: The market indexes continue to trade near their highs as they move up along the top end of the bullish channel of the past 18 months. The width of the channel is about 10%, which allows the market to have room to move and dip back, and still be in the same bullish trend. Pullbacks within overall rising trends are common and should be expected, and just because there has not been a 10% pullback in over a year does not make it less or more likely to happen. But we do see these pullbacks as inevitable, and if you have a good understanding of the longer-term trend, they can be seen as good general entry points, rather than the usually fearful events when they happen. And so while we can enjoy the market’s current strength, we also want to keep some powder dry for any future pullback opportunities that come along.
It is interesting how investing cycles work as stock groups rotate through their cycles, some of which last for months, while others last for years. It seems that a group or sector will rise until it becomes overly popular, and then it will rest, with recent examples of that kind of a trend being the Technology and international stocks, which we believe have become much more popular over the past few months, well after they moved higher. In a bull market, bottoming trends can be hard to find, so momentum trades after quick dips are a recurring theme in bull-market investing. We also like to look at those groups and sectors that came down months before, and are now in a low and bottoming process in what we call the “ignore-it” stage though this shouldn’t be confused with other sector such as Energy where we cannot yet see any kind of bottom.
COMPLACENCY (S&P P/E to VIX SPOT Ratio): 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.
Reiterating commentary in our previous Blogs, we are cautious with respect to the higher P/E’s combined with lower VIX (volatility) measurements. This complacency of rising valuations and falling volatility suggests that a market pullback is likely or at least a pause. It is a modest move relative to the overall market performance recently, however the markets need to rein in this complacency by way of a correction and an increase in volatility in order to maintain healthy market balance.
The chart above is one of the more compelling charts in this blog. It 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 chart, the market is ahead of itself and showing signs of overvaluation. The markets paused slightly, corrected and rallied again, making stocks less attractive on a fundamental and technical basis. 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 (volatility) combined with increased complacency referenced earlier, is not sustainable and the probability of a corrective has increased. As investors begin hedging their portfolios, a rise in the VIX is the most common broad market indicator.
The chart above 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.
The VIX (volatility Index) has dropped to levels that signal that the market rally could be slowing down and that a possible short-term correction could ensue. With the VIX at all-time lows (corresponding to the rally in the markets) we will be looking for a 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 over-extended and have correction risk for the short term. With the S&P off about 1% from its peak, and only has a 2% return since February, we believe that the strong uptrend of the past year is losing some of its momentum and is getting tired. At best, we see a stagnant market in the weeks ahead or even the possibly for another 5%–10% downside. 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 the intermediate to long-tern 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 equity sectors continue for several more years.
TRADING UPDATE: We have been putting a limited amount of cash to work into equities as pullbacks in specific sector and individual stocks occur. We have been rebalancing portions of the portfolios while slightly reducing the overall cash weighting in the accounts as opportunities arise. The remaining cash can be put to work quickly should we see further 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.