Volatility Index takes out its pre-crisis lows…

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The S&P 500 volatility index shows the market’s expectation of volatility over the proceeding 30 days. Since volatility is attributed to declining markets, a rising VIX usually coincides with market sell-offs, and vice versa.

Today the VIX fell to 9.37, which took out the low of 9.39 that occurred on December 15, 2006. I want to stress that this is simply an observation and not a market prediction. The VIX can stay low for a long time, and even a rising VIX is not always a precursor to a bear market.

The observation; are we becoming too complacent to the risks that equity investing represent? The fundamentals continue to improve and confirm a recovery in it’s middle to late stages. But on the flip-side, the expansion is now over eight years long, and global central banks will soon be moving to tighten unprecedentedly easy monetary policy conditions at the same time.

Chances are your not going to be able to time the next major correction or serious bear market. So the better course of action is to take a look at your portfolio now and assess whether your taking more risk than you’d be comfortable with in a bear market. It’s better to prepare now (when stocks are at all time highs) then try to re-balance in the middle of a serious volatility event.

Interest rates at key support levels…

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The 10 year US treasury bond interest rate is the benchmark for fixed income. Over the last 12 months, interest rates reached a generational low of 1.33% in July 2016. They rallied sharply post-election, almost doubling to 2.62%, on the expectation of higher growth and inflation. And have since traded sideways to lower over the last few months. Today the 10 year rate has declined back to 2.14% as I type this. However there is a confluence of support here that could potentially provide the next leg up in rates.

The chart above shows the price action. The support zone is a combination of the 38% retracement level of the rally off the 2016 lows. There is also an open gap from November 10th just a few ticks below. The support zone comes in between 2.11% and 2.13%.

I’ll be watching these levels carefully over the next few weeks. If it holds, I would expect a move higher in the vicinity of 4% (where I believe the real rate of interest should be – discussed below). If it fails, we still have the nice round number of 2%. But much time spent below that puts the uptrend in serious jeopardy.

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This decline in long term rates has flattened the yield curve to its lowest levels in 8 years. It’s something the Fed must consider as it begins normalizing monetary policy, as an inverted yield curve has been a precursor to most recessions and bear markets post WWII. At this point it’s not anything to worry about. But at some point monetary policy will become restrictive enough to expire the business cycle. We are not anywhere near that point yet.

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We must also take the global fixed income picture into context. US rates are at historic lows, but a case can be made that they still have value when taken into context with the global picture. Germany’s bonds are yielding 0.25%, and Japan is 0.03%. The only comparable yields in the developed world are Italy and Spain, both of which are currently struggling with double digit unemployment and shaky banking systems.

So what happens if interest rates continue to rally? Many have cited this market rally as being a bubble ready to explode at any moment. The problem with historical valuation methods (price/earnings, price/sales, price/cash flow, etc) is they don’t take into account for inflation and interest rates.

It’s true that trailing and forward price to earnings ratios are on the high side, however inflation and interest rates are also lower than at anytime in at least the last 20 years.

There is no perfect formula here, but I personally like using the equity risk premium as a gauge of valuation. The equity risk premium takes the earnings yield of the S&P 500 and it subtracts it from the interest rate of the 10 year.

Currently the earnings yield is 5.54% (forward S&P 500 earnings of 135 divided by the current price level of 2439), while the 10 year rate is 2.16%. This means the equity risk premium is 3.38%, which makes stocks still attractively valued even at these high levels. It also means that investors are getting compensated for the extra risks they are taking in stocks compared to the relatively risk-free rate of US treasuries.

Let’s assume the 10 year rate rallies to 4.00%, which accounts for 2% GDP growth and 2% inflation. The equity risk premium would still be positive at the current earnings yield. At some point interest rates will rally high enough to make current valuations high or even extreme. And corporate profits could decline and make the earnings yield on stocks less attractive to fixed income.

I do think there may be a bubble in corporate fixed income (and sovereigns too for that matter) as companies take advantage of low rates. But that’s probably not a near term concern as long as GDP growth and inflation remain subdued.

The key is to understand what purpose fixed income serves in your portfolio. If your looking at fixed income to continue the stellar performance of the last 20-30 years, your probably going to be disappointed going forward. You’ll probably be better off in stocks if you can handle the risk.

Most people can not stomach the volatility of being 100% in stocks. If you find yourself reacting to stock market volatility, then you know you’ve taken on more risk then you can handle. In this case bonds still serve a quality purpose, and you shouldn’t be scared out of owning bonds even in spite of the potential for higher rates in the future.

US under-performs Global stock rally…

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A lot has been made of the fact that US stocks are making new all-time highs on a daily basis, while seeming to ignore all political volatility. It’s true that volatility measures such as the S&P 500 Volatility Index (VIX) are near record lows. However when we take into account how global stocks are performing, a case can be made that investors are in fact reacting negatively to these issues.

The above chart illustrates the year-to-date performance of the global financial markets. The US large cap index (S&P 500) and US small cap index (which is a barometer of the domestic economy, since most companies in the index generate about 90%+ revenues domestically), although both positive this year, are under-performing the international and emerging market stock indexes by a reasonably large margin.

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Even if we go back to election day, US stocks still lag behind a little bit.

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Now in fairness, this is a very small sample size. If we look back over the last 6 years, US stocks crush international. So it’s quite possibly a case of reversion to the mean.

International stocks offer more attractive valuations and dividend yields. However investors should also be aware of the equity risk premium, which is still very attractive.

Small cap/Financials weakness a concern?

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One of the themes this year has been the relative under-performance of the Russell 2000 index. This index is comprised of small cap stocks that generate almost all of their revenues domestically.

The chart above shows the year to date performance of the index, struggling to stay above the break even level so far. While the S&P 500 is up close to 8.5% in that same time frame.

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In the same manner, financials have also struggled to stay positive year to date. Showing similar relative weakness.

Financials make up 14.1% of the S&P 500. So is this combined weakness in small caps and financials a threat to the advance?

Well we know that there is always going to be something to be concerned about. Investors waiting for the perfect moment will be waiting forever, and end up paying high prices whenever they do decide to jump in. That being said I think the answer to this question is simply choosing too small of a time-frame.

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If we look at a one year time-frame, all of a sudden we see that there is in fact relative strength in the Russell 2000. Outperforming the S&P 500 by almost 6 percentage points.

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Same with the financials. A one year time-frame shows relative strength, with the sector outperforming the S&P 500 by about 5 percentage points.

This of course doesn’t mean we couldn’t suffer a correction. My point is that there is no need to make any serious portfolio changes based upon five months of trading. A simple change in perspective can make a lot of difference.

The stock market has been advancing due to better earnings and global GDP growth. The earnings growth for the S&P 500 came in at 13.9% for the 1st quarter, which is the highest growth rate since Q3 2011.

Much of the rally up likely had little to do with politics. So it’s no surprise that the market has so far been able to ignore the recent headlines.

Source:

Factset

Data suggests more upside

Coming off a weekend of political disappointment, it’s easy to get caught up in the emotions of it all. As I pointed out, the market was due for a pullback, and it got a reason to. We can “beat a dead horse” and dissect all of the “what-if” scenarios and implications of the failure. But none of this will be fruitful for your investment decisions. We know that pullbacks and corrections are an inevitable part of investing. And once in awhile we get a major decline, usually due to a recession. The key question is does the data suggest a business cycle peak?

The short answer is no.

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Consumer confidence numbers just came out at a high not seen since November 2000.

Small business optimism

Scott Grannis points out that Small Business Optimism has soared post election and is near all time highs.

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Earnings growth is finally back and is projected to be around 9-11% for 2017. This would be the largest annual increase in earnings since 2011. And this doesn’t even factor in the potential for tax reform and repatriation.

And interest rates are still very low. The earnings yield on the S&P 500 is currently 5.59%, while the 10 year treasury bond yield sits at 2.38%. Even the Fed’s overly optimistic projection suggests the real Federal Funds rate won’t even turn positive until another two years or so. So, even though valuations are on the high side and interest rates have risen quite a bit post elections, stocks still present an attractive risk premium.

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An interesting chart to follow going forward is the ten year yield. Post election the 10 year yield has risen on the assumption of pro-growth policies of the new administration. Since then a trading range between 2.3% and 2.62% has been formed. An upside breakout suggests all is clear, while a breakdown suggests that more of the President’s agenda may be in jeopardy.

Time will tell. But for now, things are looking pretty good to me. But I parse this by saying we’re probably closer to the end of the bull market, than we are to the beginning. The stock market and the economy don’t always correlate. We’ve had great performance in stocks over the last 8 years, while the economy largely under-performed. I wouldn’t be surprised if, going forward, we experience a situation where the economy starts to outperform, while stock performance slows down to an eventual crawl.

The great thing about diversification and asset allocation is that we don’t have to be prophetic. We stick to our strategy and re-balance when necessary. It’s that simple, but certainly not easy.