Volatility Is Set To Increase

Summary: On Tuesday, VIX closed below its lower Bollinger Band for the first time in a year. In the past, this has very often led to at least a 5-10% increase in VIX in the weeks ahead. But the affect on SPY has been mixed; just over half of instances were followed by a decline of at least 1% in the week ahead.

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VIX measures the market's expectations for volatility over the next month. A low VIX implies that expectations are for little volatility looking ahead. Today's VIX is near 12, one of the lowest levels in the past year. Given the small daily and weekly movements in the SPY over the past several months, it is not surprising that VIX is low.

Bollinger Bands measure the movement of price around its mean. Using the most common set up, a movement outside of the upper or lower Bollinger Band is equal to 2 standard deviations from a 20-day moving average. Price should only fall outside of the upper or lower Bollinger Band only about 5% of the time so when this occurs, it is noteworthy.

On Tuesday, VIX closed below its lower Bollinger Band for the first time in more than a year. In the past 5 years, this happened only 15 times.

What happens next?

VIX itself has a strong tendency to rise in the days and weeks ahead. In 14 of the 15 instances, VIX increased by at least 5% and it increased by more than 10% in more than half of all instances.

Normally, SPY moves opposite to VIX; so an increase in VIX would typically lead to a decline in SPY. But that's not always the case and in the 15 cases where VIX closed below its lower Bollinger Band, SPY fell more than 1% only about 60% of the time. Stocks have a natural tendency to rise, so the likelihood of a decline is slightly elevated, but the edge is not significant.

The charts below show every instance where VIX closed below its lower Bollinger Band since 2010 (vertical lines). SPY is in the top panel and VIX is in the lower panel. A rise of more than 1% in SPY is highlighted in green, a decline in yellow. The same applies to VIX, except the threshold is a rise or fall of more than 5%.

In 2014, there were 3 instances when VIX closed below its lower Bollinger Band. VIX rose every time, once by more than 10% (lower panel). SPY fell by more than 1% twice but rose unabated once. The overall uptrend in SPY was not affected.

Weekly Market Summary

Summary: US equities are slowly trending higher but have refused to become either oversold or overbought during the past several months. They reached slightly overbought last week; thus, an opportunity to finally build on strength has once again arrived. But breadth has not washed out to a low and sentiment is still leaning bullish. None of this suggests a runaway to the upside is imminent.

Seasonality during the upcoming week has been uniformly bad the past 17 years. The good news: among the summer months, July is a bullish standout, something to keep in mind should stocks encounter weakness over the next several days.

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US equities moved higher this week: SPX and DJIA gained about 0.7% while NDX and RUT gained about 1.4%. Of note, small caps and the broad Nasdaq index (COMPQ) closed at new all-time highs (ATH).

Foreign indices closed lower: Europe lost 1% and emerging markets lost 0.5%. Most foreign markets are making lower lows under falling 50-dma.

US equities rose to relative highs at the end of last week before turning down on Friday. Since December, US stocks have not been able to move much higher after becoming slightly overbought (daily RSI(5) over 70; arrows). The only exception was in February, and all of those gains were given back in March.

Bottomline for the week ahead: is this pattern set to change?

Fund Managers' Current Asset Allocation - June

Summary: Overall, fund managers' asset allocations in June provide a confused view.

On the one hand, fund managers raised cash to a 6-month high and reduced their global equity exposure to an 8-month low. Relative to recent history, this is contrarian bullish.

Note, however, that most of the fall in their equity allocations came from further reducing emerging markets exposure; allocations to Europe and Japan were largely unchanged.

Moreover, fund managers remain very overweight "risk on" sectors: discretionary, banks and technology. Allocations to defensive sectors, like staples, are near all-time lows.

Regionally, allocations to the US and emerging markets are at low levels from which they normally outperform Europe and Japan on a relative basis.

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Among the various ways of measuring investor sentiment, the BAML survey of global fund managers is one of the better as the results reflect how managers are allocated in various asset classes. These managers oversee a combined $600b in assets.

The data should be viewed mostly from a contrarian perspective; that is, when equities fall in price, allocations to cash go higher and allocations to equities go lower as investors become bearish, setting up a buy signal. When prices rise, the opposite occurs, setting up a sell signal.

To this end, fund managers became very bullish in July, September, November and December 2014, and stocks have subsequently sold off each time. Contrariwise, there were some relative bearish extremes reached in August and October 2014 to set up new rallies. We did a recap of this pattern in December (post).

Let's review the highlights from the past month.

Fund managers increased their cash levels to a 6-month high of 4.9%. While this is relatively high on a historical basis, note that cash levels haven't been much below 4.5% since early 2013.  Nevertheless, this is normally bullish for equities. 

The Current Sideways Trading Pattern Could Go On Much Longer

Summary: Long periods where the S&P trades sideways in a range is not unusual. There have been at least 15 similar situations in the past 35 years, about one every two years. Some of these have lasted as long as two years. Most of these have resolved with the S&P moving higher. We've been in a trading range for 7 months; settle in, this could go on much longer.

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Over the past 7 months, the S&P has traded in a range of about 7%. After the high volatility of 2009-12 and then the rapid, uncorrected appreciation of 2013-14, this seemingly tight trading range is being regarded as an anomaly.

Is it unusual? Or bearish?

The answers are 'no' and 'not necessarily'. Over the past 35 years, there have been trading ranges as tight that have gone on for much longer, some as long as two years. Most of these have resolved with the S&P moving higher.

In the charts below, the current trading range is highlighted in green and transposed on prior periods that are largely similar. All of the green boxes are the exact same size.

Starting with the current bull market, the current trading range is almost identical to the one that lasted from January until August 2011. That one ended badly.

How Investors Are Positioned Heading Into Mid-Year

Summary: The latest data from the Federal Reserve and ICI, a company that measures equity money flows, show that US households have been aggressively adding to their equity exposure and reducing their cash. As the bull market has matured and investor confidence has increased, money has increasingly flowed to foreign equity markets, especially in 2015.

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The latest Federal Reserve flow of funds data (Z1) provides an up to date view of households' current asset allocation. Let's review.

Household's largest holding continues to be in equities; these comprise about 31% of their total financial assets. Current levels are above the recent highs of 29% in mid-2007; it reached an all-time high of 36% in 2000. In short, as the bull market has matured, households have become comfortable holding equities.

Weekly Market Summary

Summary: US equities have refused to become either oversold or overbought during the past several months. They are now down two weeks in a row and at point similar to where there has recently been a bounce higher. Failure to do so now would mark a change in character for this rangebound market. Ultimately, the washout low probably still lies ahead.

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For the week, SPY and NDX lost 0.6%, but RUT gained 1.2% as investors rotated into lagging small caps.

Overseas markets performed much worse: Europe lost 2.7% and emerging markets lost 2.5%.

US 10 year treasury yields rose to their highest levels since October. TLT lost 4% this week.

SPY and NDX have now fallen the past two weeks in a row. If the pattern of recent months holds, US equities are at or near at point where they will bounce, even if it is short lived.

On a weekly scale, SPY is within 1% of a rising 4 year trendline. We have remarked repeatedly how SPY has not become oversold or overbought in 2015 (top panel); since December, SPY has risen the following week after RSI(5) is at current levels (green lines). Failure to do so would mark a change in market character.

Margin Debt Levels At Relative Highs

Summary: Margin debt levels are at all-time highs, on an absolute basis and as a percent of market capitalization. What does this imply?

• High margin debt mostly tells us that investors are bullish on equities; there is no other reason investors would be using so much leverage to buy stock. A high proportion of bullish investors usually leads to slower future stock market appreciation as there is less fuel to drive prices higher. 
• Beyond that, it is is difficult to make definitive conclusions on what high margin debt implies for equities looking ahead. 
• Could margin debt rise further? Yes, it could continue to rise at the same rate as market capitalization and, objectively, not be out of proportion. But a dramatic increase, like in 2012-13, that turbo-charged the equity rally, is probably not likely.  
• Could the stock market fall 10% or more? Yes, highs in margin debt have coincided with near term highs in the market. There's no need for margin debt to fall ahead of stock prices.

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The "margin debt" levels for the NYSE have received a lot of attention this week. In April, margin debt increased by 6.5% from March to $507b. This is a new all-time high in both nominal and inflation-adjusted (real) terms.

What is margin debt? Customers can borrow (cash) against the assets (stocks) in their brokerage account. Most often, this new cash is then used to buy more stock. High levels of margin debt means that investors are leveraged long, a sign that they are bullish equities.

So it should be no surprise that margin debt and equity prices move up and down together. As equity prices rise, customers have greater assets to borrow against, and using borrowed cash (leverage) to buy more stocks makes equity prices rise faster. That is what has happened in the past three bull markets (chart from Doug Short).

June Macro Update: Employment, Wages and Housing Lead Higher

Summary: This post reviews the main economic data from the past month.  Highlights:

• Employment: The average monthly gain in employment during the past year was 256,000, the highest since the 1990s. Annual growth in employment is the best in 15 years. 
• Wages: Wages have recently started to accelerate. The 1Q15 Employment Cost Index rose 2.7%, the highest since the recession. Hourly earnings growth in May was the highest since the recession.
• Demand: 1Q15 real GDP grew 2.7%, the second highest rate in the past 5 years. Real personal consumption (70% of GDP) grew 3.0% in 1Q15, the highest rate of growth in 5 years.  
• Housing: Housing starts in April rose to a new 8 year high. New home sales are near a 7 year high.
• Inflation: However, the core inflation rate remains under 2%. It is near its lowest level in the past 3 years  

Bottomline: the trend for the majority of the macro data remains positive.

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A year ago, we started a recurring monthly review of all the main economic data (prior posts are here).

For most of that time, the consensus view has been that growth in wages and employment would soon accelerate and that this would lead to a meaningful increase in inflation above the Fed's 2% target. Our monthly review of the data has consistently shown this expectation to be premature.

The irony now is that economic data has seemingly turned negative over the past three months, to the point where many talk about a recession or QE4. We think this weakness is temporary, mostly driven by the huge drop in energy prices which has lowered inflation and depressed "nominal" price growth. "Real" growth remains positive.

More importantly, the fact that the consensus swings between extremes underscores how focused too many are on monthly data points, with the effect that underlying trend in the data is missed.

Bottomline: the trend for the majority of the macro data remains positive.

Our key message has so far been that (a) growth is positive but modest, in the range of ~3-4% (nominal), and; (b) current growth is lower than in prior periods of economic expansion and a return to 1980s or 1990s style growth does not appear likely. This is germane to equity markets in that macro growth drives corporate revenue, profit expansion and valuation levels.

Let's review each of these points in turn. We'll focus on four categories: labor market, inflation, end-demand and housing.


Employment and Wages
The April non-farm payroll (280,000 new employees) was the highest so far in 2015. Prior to March (a disappointing 119,000), NFP had been above 200,000 12 months in a row, the longest streak since 1993-95. April and May were therefore a bounce back to trend.

In the past 12 months, the average gain in employment was 256,000, the highest since the 1990s.

Monthly NFP prints are normally volatile. Since 2004, NFP prints near 300,000 have been followed by ones near or under 200,000. That has been a pattern during every bull market.  So while the March print of 119,000 was lower than expected, it fits the historical pattern. A low print was long overdue.

Interview With Financial Sense on US Macro and the Non-Trend in Equities

We were interviewed by Cris Sheridan of Financial Sense on May 22. During the interview, we discuss market the macro environment, San Francisco real estate and the horizontal trend in US equities.

Our thanks to Cris for the opportunity to speak with him and to his editor for making these disparate thoughts seem cogent.

Listen here.

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