Low VIX is not a sell signal

Today the VIX has traded below 13.  I have read many comments on Twitter in the past about how a low VIX is bearish and evidences complacency.  As always, I have no clue where the market is going next, but based on history a low VIX reading suggests that we should be prepared for a greater possibility of higher prices with less risk of drawdowns over the next 5-6 months.

As shown in the table below, the lower the VIX the greater the historical probability of SPY trading higher in 100 days. Also, the average winner/average loser has been higher and the average drawdown has been lower.

If you are short and basing that decision on a low VIX, you may want to reconsider.

VIX Table

Market Update

Things have certainly deteriorated over the past couple of months. Seems like a good time to review where things stand and check some of the indicators I follow.

Let’s begin by looking at momentum and trend of global equities (VT). Both have turned lower as measured by the 1-year rate of change and the 210 DMA.

VT Trend

There is absolutely nothing special about these methodologies. But most intermediate term moving averages and look back periods have turned negative.

US equities have performed better this year, but they too are now trending lower. Year over year momentum is still slightly positive.

VTI Trend

The deterioration has been broad based. As of yesterday, only 26% of stocks on the NYSE are above the 200 DMA.

NYA

Also, cumulative new highs minus new lows on the NYSE are trending lower (below 50 DMA). As can be seen from the following chart, this is often associated with periods of market stress.

nhnl

High yield credit spreads are widening as seen by the 3-month rate of change of JNK relative to IEI.

jnk

High yield was hanging in until recently. The collapse in oil prices likely pushed spreads higher.

WTIC

So trend is down, momentum is down, breadth is poor and credit stress is increasing. Not a great backdrop.

Not surprisingly, many people have decided to exit, perhaps at the request of their friendly brokerage. In October margin debt fell by 6.25% month over month. This is a large drop. As a result, year over year margin debt growth is now negative (see FINRA data). A source of liquidity is leaving the market.

So, where to from here?  Obviously, I have no idea.  Economically, at least in the US, things are not recessionary and it seems unlikely that a recession is imminent.  Unemployment is very low and not yet trending higher, retail sales are still strong, industrial production is strong.  Housing is the weak link, likely as a result of higher interest rates.  This is troubling, but overall the balance of the evidence suggests that the economy in the US is slowing but not close to recessionary.

Assuming this is correct, we are likely experiencing a non-recessionary correction that may morph into something more serious probably as a result of something that is not on anyone’s radar.

I do not get the sense that there is any real fear in the market, as compared previous corrections since 2008.  This is just a personal “feeling” and not data based.  Although a bounce is certainly possible at any point, I think the market is not done correcting.  Caution is warranted.

My weekly allocation according to the VT Model on this site is now 40% VT and 60% IEF.  Exposure to equities has been greatly reduced over the past month.

When cash is no longer trash

With the Federal Reserve raising rates over the past couple years and the stock market moving higher, the yield on 1-Year T-Bills now exceeds the dividend yield on $SPX. As can be seen on the following chart, the ratio of the 1-Year T-Bill yield to $SPX dividend yield is now 1.46.

Div Yield

This is not high by historical standards. The average ratio since 1970 is 1.78, so it is still below average.

I drew an arbitrary line on the chart at 2.75. This has been an approximate peak level on a number of occasions.

I looked at all new instances since 1970 where the ratio first hit 2.75 (had not been at or above 2.75 within the prior 6 months). The following table shows these occurrences, as well as the most proximate recession.

Yield and Recsession.JPG

The next table shows the 1, 2 and 5 year price returns for $SPX following these occurrences as well as the max drawdowns in the subsequent 5 years.

Yield an d

From the table we can see that the ratio has hit 2.75 in the 1-5 years that have preceded the largest drawdowns since 1970. With the exception of the late nineties, where the ratio surged all the way to 5.75 and the market did not put in a meaningful top for just over 3 years, a significant market top and drawdown occurred within a couple of years.

Assuming that the Federal Reserve continues to tighten at its anticipated pace, and the market stays flat, it is likely that we will hit the 2.75 ratio some time in 2019. What would happen after is not possible to predict with this historical information and such a small sample size, so I would certainly not be rushing to short the market if we were to get to that level solely based on this historical information. There is nothing to say that the ratio could not go to 5.75 again like in the late nineties, or even beyond. It is also possible that the ratio could peak lower than 2.75 in this cycle.

However, I think that psychologically a 1-Year T-Bill rate that is almost 3 times the $SPX dividend yield would cause people to think twice about holding stocks, especially given current valuations. Risk of a large drawdown would be elevated in my opinion, so at the very least caution would be warranted. I will revisit this if it occurs.

P/E 10 in Dec 2019

I just watched a useful video by ReSolve Asset Management on the P/E 10 ratio (or CAPE 10), which discussed the rising trend in this ratio (click here for video).

It made me curious to see the impact of the depressed earnings of the financial crisis on the P/E 10, in particular because these earnings will begin to fall off beginning next year. Below are the annual S&P 500 earnings for the past 10 years up to Dec 2016 (data from www.multpl.com):

Date                Earnings

Dec 2016           95.76

Dec 2015           89.46

Dec 2014           106.54

Dec 2013           105.13

Dec 2012           92.13

Dec 2011           94.12

Dec 2010           86.29

Dec 2009          57.71

Dec 2008          17.31

Dec 2007          77.05

As you can see, 2008 and 2009 earnings were disastrous.  What will happen to P/E 10 when these earnings are replaced with earnings in 2018 and 2019?  Of course, we have no idea at this point.  They could be recessionary earnings as well and equally disastrous.

For entertainment purposes though, let’s assume that S&P earnings between 2017-2019 are flat with 2016 earnings.  As at Dec 2016, the average annual earnings over the prior 10 years was 81.2.  If we apply our assumption of flat earnings between 2016 and 2019, average annual earnings in Dec 2019 would jump to 95.7.  This would be a 16.5% bump to the 10-year average earnings from Dec 2016.  Note that these numbers are not inflation adjusted, but sufficient for illustrative purposes.

If the S&P 500 were to trade flat between now and Dec 2019, the P/E 10 (again not inflation adjusted) would drop around 14%.  It would still be elevated by historical standards, but a little less so.

I understand that this is cherry picking data and I am not trying to justify current valuations which are above historical norms based on a number of metrics (EV/EBITDA, price/sales, price/book, etc.).  I also know that valuation measures have zero utility for short term market timing.   It is simple to show that the P/E 10 ratio “could” correct over the next couple of years and look less obscene as 2008 and 2009 earnings fall off, even with zero earnings growth.