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Volatility Traders Aren't Buying The Rally

Submitted by Lance Roberts via STA Wealth Management,

Strong October Leads To...

Following the sharp August and September correction, the markets have advanced roughly 17% in less than three months. Which is pretty incredible considering that the Fed is discussing tightening monetary policy while the rest of the world loosens it amid fears of a global slowdown. 

I have discussed over the last couple of weeks the entrance of the markets into the seasonally strong time of the year, to wit:

""The table below shows the statistics of the seasonally strong/weak periods of the S&P 500 from 1957 to present using the data from the Federal Reserve (FRED).

As noted above, there is a statistical probability that the markets will potentially try and trade higher over the next couple of months particularly as portfolio managers try and make up lost ground from the summer.

 

However, it is important to note that not ALL seasonally strong periods have been positive. Therefore, while it is more probable that markets could trade higher in the few months ahead, there is also a not-so-insignificant possibility of a continued correction phase.

 

Furthermore, the probability of a continued correction is increased by factors not normally found in more "bullishly biased" markets:

  • Weakness in revenue and profit margins
  • Deteriorating economic data
  • Deflationary pressures
  • Increased bearish sentiment
  • Declining levels of margin debt
  • Contraction in P/E's (5-year CAPE)

(For visual aids on these points read: 4 Warnings)

It is the highlighted lines above that are most important to today's discussion. 

Adam Shell via USA Today had a good piece of analysis supporting the possibility of a weaker end-of-year run in the markets. 

"Although November has been the Dow Jones industrial average's second-best performing month the past 20 years (gaining an average 2.4% and finishing up 70% of the time), the market has posted slightly negative returns (-0.12%) in November after the S&P 500 gains 5% or more in October, Bespoke Investment Group data since 1928 show.

 

The most recent example of the stock market pausing in November after a big October rally occurred four years ago. After the S&P 500 rallied nearly 11% in October 2011, stocks fell 0.51% that November and were up just 0.34% in the final two months of 2011. Ironically, many Wall Street pros have been saying that this year's market performance is tracking very closely to the ups and downs of the market back in 2011, when the S&P 500 finished the year virtually unchanged.

 

The takeaway: Don't expect the year-end rally to be quite as robust following last month's huge run-up."

Adam is correct in his analysis. As I discussed this week, there are many hoping that the summer correction is a repeat of the 2011 selloff which was simply a pause in the continuance of the bull market rally. But there are many differences this time, with the most important being the Fed's ongoing determination to "tighten" monetary policy rather than loosening it. 

Nevertheless, the vast majority of commentators, bloggers, etc. are dismissing the ongoing weakness in the underlying economic data with hopes that a resurgence of activity will appear in the months ahead. Such will likely not be the case as the deflationary backdrop continues to plague global economies.

For now, the bulls are clearly in charge of the market keeping allocation models more heavily tilted towards equities. However, like watching close-up magic, do not let your attention be diverted from the "hand that just picked your pocket." 

 

Net Exports Suggests Weaker GDP

Part of the GDP calculation is the subtraction of imported goods and services from exported goods and services or "net exports." This is shown in the chart below.

On closer inspection, there is more to the story than just the net difference between imports and exports. Take a look at the previous two recessions above. Notice that in each instance there was a very sharp decline in imports (which suggests weak domestic consumption) which was greater than the decline in exports. This sharp decline in imports is NOT a positive signal for future economic growth. 

This is shown more clearly in the annual rate of change of imports and exports below.

The sharp rise in the dollar, which has been cited by many companies as the reason for weak earnings results due to the negative impact to exports, should be a boon for consumers as the stronger dollar makes imports cheaper. However, that has clearly not been the case and suggests the domestic consumer is substantially weaker than other headline data suggests. 

When a large percentage of consumer spending is consumed by rising healthcare costs (Thank you Affordable Care Act) it diverts spending away from consumption that would otherwise boost economic activity, create employment and foster higher wages. However, because healthcare service spending has risen so strongly over the last few quarters, it makes personal consumption expenditures appear economically stronger than it is. 

The import/export data is suggesting that the global weakness arising from China and the Eurozone have now impacted the domestic economy. While the Fed continues to suggest that economic strength is improving, the underlying data continues to suggest it isn't. 

 

Volatility Traders Aren't Buying The Rally

Interesting note from Sentiment Trader:

"This is the fifth time in the past three years that the VIX rose 2% of more on a day the S&P 500 also rose, and short-term volatility expectations were at least 10% below longer-term volatility expectations. Those dates were:

  • September 14, 2012
  • January 21, 2014
  • August 25, 2014
  • May 18, 2015

Over the next month, the S&P 500 was not able to gain more than +1% at its best point, and suffered a loss averaging -3.2% at its worst point. Quite a negative reward-to-risk ratio."

The chart below is a "weekly" chart of the ratio between the Mid and Short-Term Volatility Index. I have indicated points where the ratio turned up sharply from lows which has led to poorer future performance from the index. While it is still early at this point, the recent deviation between the VIX and the index suggests that traders are indeed not "buying the rally." 

Just something to think about.