The “Nothing Matters” Market
The “nothing matters” calls from pundits seem to be picking up steam. Low volume? doesn’t matter, low VIX? doesn’t matter, participation rates? doesn’t matter, market structure issues? doesn’t matter, corporate profits?? Doesn’t matter…. According to what many pundits out there seem to be saying, none of the above matters because the Federal Reserve has said they will ease for as long as necessary to get unemployment to 5.5% and the economy moving again…
In general terms, fighting the Fed has been a losing proposition going back to the period following the Great Depression but in all fairness, we have not seen Fed intervention to this magnitude before. Fair to say that we are in unchartered waters in this regard and while future generations will be able to look and analyze the “causes and effects” of these extraordinary economic times, we, at the present moment can only define the “causes” and speculate on the “effects”.
Nonetheless, I am not ready to buy into the “nothing matters” argument.
Trading volume for example has been on the soft side for some time now. There are many reasons for this such as the higher average price of stocks these days but the real issue when considering volume is its composition and general participation.
In the past, market volume was comprised of much more retail based, individual investors along with traditional institutional volume and since the early ‘00s, the high frequency and algorithmic traders. Today the retail investor is missing in action, institutions are trading much more in Dark Pools of liquidity outside of the NYSE and high frequency and algorithmic traders make up between 60 and 70% of all trading volume. No matter how you slice it, volume and participation matter.
I think corporate profits also matter
as do the multiples that investors are willing to pay in this environment. I think we are living in a “show me market” where higher valuations will only come about through profit expansion. Analysts and investors will be very careful to pay much higher multiples in this environment of uncertainty and lack of visibility.
While there is room for some multiples expansion and I do think investors will pay slightly higher multiples soon, I don’t buy the “parabolic” move higher in equity prices many are forecasting. I think the fact that we are still fighting to ignite some measure of inflation after so many of these easing programs should raise a red flag that investors are not going to drink the “magic potion” and buy risk assets indiscriminately as perhaps the Fed wants them to.
Market structure matters. Although I think I am pretty well versed in these structural issues, there are many out there that are much more in tune to the pitfalls of these deficiencies. If you are on Twitter, I strongly recommend you follow Eric Scott Hunsader @nanexllc for real insight into the issues plaguing the market today in regards to structure.
Complacency also matters
when complacency reaches extreme levels, the market tends punish those who disregard it. When too many participants forget that markets can go also down , the market has a way to remind folks of how things work.
There are several ways to measure complacency in the market place but the simplest yet effective method is to analyze the action in the cash VIX over the near and intermediate timeframes. Comparisons to periods too far in the past are meaningless because of the many other variables that need to be considered.
The cash VIX gives us a good picture of investor’s appetite for protection using SPX near term put options (30 days out). The VIX presents a picture of what investors are willing to pay in premium over historical volatility for the next 30 days. Complacency is subjective. One trader may look at a VIX reading of 15 and compare it to an actual statistical volatility reading of 10 and have an opinion that markets are not complacent while others can view it as the market discounting the importance of risks ahead.
One objective way to view this
is to take a historical view of how markets have performed at different VIX readings over a specific period of time. Again we want to stay within an intermediate timeframe to get an accurate picture and I like to compare cyclical periods within established longer term trends.
The most recent cycle comprises the bullish period from 2009 to the present. Below are charts of the SPYs and the VIX, weekly charts going back 5 years. So in brief, the VIX is another one of those indicators that shows true trader sentiment because it is backed by up with actions and not only words.
Within a look back period of five years, these levels below 14 have meant complacency and the market has punished that complacency by backing away every single time. Why does it back away? Because when traders are not properly hedged, they are apt to sell positions quickly at any sign of trouble. When traders are properly hedged, they are apt to be more patient with their thesis before changing course. Can the VIX push even lower ? Absolutely yes .
(real, actual vol) has been very low and many interpret this as a confirmation that volatility is properly priced or even perhaps expensive at these current levels. By this definition, they could be correct. My take is that within this specific look back period, it is undeniable that the market has had trouble dealing with volatility at these low levels. Could it be different this time? Yes but I don’t believe so.
Markets are extended here and the market is complacent to risks. Volatility is very underpriced and the market may be under hedged to deal with a very weak earnings cycle ahead or any shock event. The bullish technical regression channel from June 4th is intact and we should eventually resolve higher, but I am not yet convinced that everything just doesn’t matter anymore…