U.S. equities touch new highs, still boring!

May 10, 2017

Article by ForexTime

The best way to describe recent market price action is boring. Although S&P 500 touched a new record-high on Tuesday, the index has been trading in a range of less than 0.5% for the past ten days, and when excluding the rise of 0.41% on 5th May, it was a trading range of less than 0.2%.

Low volatility indicates that investors seem to be relaxed for now. Although they’re not willing to take much risk, they aren’t worried about a sharp correction. Multiple factors may explain the low volatility: steady earnings, stable economic indicators, and a decline in equities correlation, limiting a one-sided move. One of the questions I hear all day, is how long can this prolonged period of low volatility last? But the more important question should be, what direction are equities going to take when volatility returns?

First, let’s examine how markets reacted in the immediate aftermath of historic low volatility levels:

July 1993: The VIX fell to 9.11, S&P 500 gained 3.6% in the following eight weeks.

December 1993: the VIX dropped to a low of 8.89, four weeks later the S&P 500 surged 2.6%, then fell by more than 7% in two months.

December 2006: the VIX fell below 10. S&P 500 posted gains of 3.25% in ten weeks, followed by a 6.7% correction.

The takeaway from these samples is that for the most part, when the VIX falls below the 10 benchmark, equities make short-term gains, followed by a correction. On the longer-term, it’s much different. For example, in 1995 the S&P 500 surged 37.2% and in 2008 crashed 36.55%, suggesting that the VIX is a poor indicator of long-term trends.

A period of very low volatility doesn’t persist for long, and it only needs little surprises, whether it’s macro factors, a change in earnings expectations, or a political shock to change investors’ behavior.

I still believe that valuations are overstretched, and if not supported by stronger earnings in the next two quarters, it will be hard to justify current price levels, especially considering that fixed income instruments will become more attractive as the Fed and other central banks start tightening monetary policies. I will also keep a close eye on oil prices, although I believe that we’ll be ending the year above $50. Any sharp move to the downside from current levels will drag equities with it.

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Article by ForexTime

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