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.