Owen Williams: Report for week ending Apr. 7, 2017
  • April 10, 2017 11:38 pm
  • by Bill Cara

Three More Indicators Screaming “Move Into Cash”

Despite a week marked by surprises, from a U.S. missile strike in Syria to a jobs report that was the weakest in almost a year, U.S. equities remain unperturbed while VIX tallied its 103rd session below 15, the longest streak since February 2007. The current U.S. equity bull market has been called “most hated bull market” and the “Teflon market” (as no bad news sticks). The rally off 2016 lows has confounded the majority of market observers, who had systematically predicted doom, first with slowing Chinese growth, then due to Federal Reserve rate hikes, then with the fall-out from Brexit, and finally with the election of Donald Trump. The “smart money” (bearish billionaires club and company insiders) is saying that it’s time to flee equities, but not many are listening. Equity valuations are the third highest on record accord to Robert Shiller’s cyclically adjusted price/earnings (CAPE) ratio. The first chart below shows that current valuations according to this metric are at the level which preceded the 1929 market crash. Moreover, in this week’s release of the FOMC minutes from the March meeting, committee members “viewed equity prices as quite high relative to standard valuation measures”. What?! These ding-dongs have been blowing a financial asset bubble for the past eight years and are just now recognizing equities might be a “bit expensive”?? Valuations aside, the Federal Reserve is increasing rates and discussing shrinking the size of its balance sheet, which incongruently is now being billed as now a positive for equity markets. How sopping up liquidity, in a market being supported only by liquidity, can be positive is beyond us. The Dow Jones Industrial Average shot up +18% on what is being attributed to speculation on Trump’s economic programme to restart economic growth…even as the political likelihood of seeing Trump’s agenda passing Congress is fading. It seems that U.S. equity markets should come down hard. But, as is often the case in financial markets, perception does not equate to reality.

 

We believe U.S. equities are in a bubble, and as such, sentiment will be a difficult (if not impossible) indicator to determine when the markets reach a sentiment extreme. With the likelihood of seeing several “false starts” to the downside before the painful correction/bear market hits, we look at several indicators in this week’s Commentary which should help filter out the drops in the S&P 500 that will be caught by the dip- buyers.

VIX Spread
The spot VIX volatility index is a coincident indicator with the S&P 500 price. When the real correction (or beginning of the next bear market) hits, the VIX will spike at the same time the S&P 500 plummets. We have advanced that a VIX index close above 15 would suggest that a deeper correction in U.S. stocks is in the works. Another way to use the VIX volatility is to compare the current month contract (anticipated volatility over the next 30-days) with the 6-month out VIX contract. This spread provides a more leading indicator of anticipated equity price movements. Recall that the VIX contracts are typically in contango – further out contracts are priced higher than shorter-term contracts. As the spread between the near-term VIX contract and longer-dated VIX contracts narrows (falling contango), the curve in our chart below rises. A narrowing spread is indicative of equity hedgers anticipating more volatility near term. We found that falling contango (a rising curve in our chart) has generally corresponded with periods when caution towards equities has paid off. Conversely, once the VIX spread begins widening, getting aggressive on the long side has provided winning trades. With the VIX spread currently in an uptrend (narrowing), we recommend waiting to buy U.S. equities. The risk is rather elevated of seeing a dip in the S&P 500 extending lower with VIX contango currently falling.

 

Equity class rotation
A second indicator that may be useful in confirming the validity of the next attempted sell-off is the relative performance of blue chip stocks to riskier, high beta stocks. In our U.S. and European Market Risk Indicators, we model several binomial pairs of asset classes that measure the risk attitude of the markets. One asset class pair in our U.S. Market Risk Indicator is the relationship between the top 100 blue chip companies versus the Russell 2000 small cap index. We charted the ratio of the S&P 100/Russell 2000 below. This isn’t rocket science, folks. Trading in-line with the trend on this chart has given exceptional outperformance since 2009. To help eliminate the noise on this chart (the wiggles in the curve), we slapped a 50-day moving average on the chart (red-line). With the 50-day moving average clearly having made an inflexion, the probability of S&P 500 posting negative returns during the coming period is high. Readers can learn of other asset class pairs that we found to have statistically significant relationships on our Model Explanation page.

 

Falling participation
Typically the number of stocks participating in a market advance tends to fall as the movement gets exhausted. That is, fewer and fewer stocks contribute to the progression of the composite stock market index as a top is reached. Our next indicator looks at the percent of stocks in New York Stock Exchange Composite Index (over 1900 stocks) that are trading above their 200-day moving average. The chart below takes the weekly close of the NYSE Composite Index (in red) with the weekly average for the percent of stocks in an uptrend, trading above their 200-day moving average (in blue). Since the bull market began, we have observed that divergences between the two curves, when the NYSE Composite makes a higher high but the “percent above curve” makes a lower high, have been resolved by pull-backs in U.S. stocks. With the percent of stocks trading above their 200-day moving average clearly forming a lower peak today relative to the prior peak in September 2016, another divergence is appearing on the chart. Given the outcome on the NYSE Composite Index following the prior occurrences of such divergences, we prefer stepping aside and watching this divergence play out before committing our money.

 

Conclusion

Sector rotation out of riskier stock classes and falling participation in the U.S. equity rally suggest that conditions are favourable now to see a deeper correction. Seeing the VIX close above 15 and the VIX contract spread narrow further will add further evidence that the next dip will be the one to sell.


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