Volatility—What Goes Down Must Come Up, But It Can Take a Long Time!, May 10, 2017

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Historically low volatility is becoming a bigger topic in the markets these days, and while earlier in the year low volatility was referenced with more of an observational tone, recently I’ve been hearing the bears touting low volatility as something that simply must revert soon, and as such we should be cautious on markets.

VIX volatility - What goes up must come downI don’t have a crystal ball, so I don’t know when normal volatility will return. However, I do want to spend a few moments pushing back on the idea that low volatility by itself means a correction is coming (obviously volatility will return, but as usual the key question is “when,” and ultra-low volatility doesn’t always mean it’ll return to normal levels soon).

First, you’re not seeing things. Volatility is at multi-decade lows, and that can be seen in multiple ways. First, the VIX hit a 23-year low yesterday, falling to the lowest level since 1993.

Second, so far in 2017 the S&P 500 has moved more than 1% on just three separate days, all of which were in March. By this time of year we’ve normally had 19 days where the S&P 500 has moved more than 1%.

Third, with a close at 9.98 yesterday, the VIX now is lower than nearly 99.5% of all the closes since Jan. 1, 1990. Put another way, it’s only closed this low about 0.05% of the time during the last 27-plus years. So, the VIX is extraordinarily low.

But, that doesn’t mean it’s going to bounce back soon.

First, According to a note from ConvergeEx, the all-time low for the VIX 50-day moving average is 10.8, which it hit in Feb. 2007. Right now, the 50-day moving average for the VIX is 12.17.

Takeaway: It’s very unlikely that the VIX will stay at these ultra-low levels for very long, but that doesn’t mean a big rally is looming. It would take several more weeks of VIX at these levels to drag the 50-day MA down towards the all-time lows.

Second, looking at the VIX to measure volatility can cre-ate a bit of an odd picture, because again the VIX is based on options prices and not the actual price move-ments of the S&P 500. Looking at actual stock price movement, it confirms what our eyes tell us.

Going back to the 1950s, the current volatility of stock prices is 48% of its longer-term average. That’s really low. And, this period of historically low volatility has been going on for 78 days (including yesterday). But, that doesn’t mean it necessarily will bounce back.

First, there have been two specific periods of similarly low volatility in the last 20 years. First in mid-2014 (75 days) and second from Nov. ’06 to March ’07 (79 days).

Second, we’re not even close to the record for low volatility. In 1992/1993 and 1995/1996 we saw respective periods of ultra-low volatility last for 179 and 254 days, respectively. That’s double and triple what we’ve seen so far in 2017.

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Earnings Season Post Mortem & Valuation Update, May 9, 2017

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The S&P 500 has been largely “stuck” in the 2300-2400 trading range for nearly 10 weeks, despite a big non-confirmation from 10-year yields, modestly slowing economic data and political disappointment. Given that less-than-ideal context, the market has been downright resilient as the S&P 500 only fell to around 2320ish. The main reason for that resilience is earnings and valuation.

While it’s true that stocks are at a valuation “ceiling” right now, and need a new macro catalyst to materially breakout, it’s also true that given the current macro environment the downside risk on a valuation basis for the market is somewhat limited. That’s why we’re seeing such aggressive buying on dips.

Here’s the reason I say that. The Q1 earnings season was better than expected, and it’s resulted in 2018 S&P 500 EPS bumping up $1 from $135-$137 to $136-$138. At the higher end of that range, the S&P 500 is trading at 17.4X next year’s earnings. That’s high historically to be sure, but it’s not crazy given Treasury yield levels and expected macro-economic fundamentals.

However, if the S&P 500 were to drop to 2300 on a macro surprise, then the market would be trading at 16.67X 2018 earnings. In this environment (low yields, stable macro environment), that could easily be considered fairly valued.

Additionally, most analysts pencil in any help from Washington (including even a small corporate tax cut and/or a foreign profit repatriation holiday) adding a minimum of $5 to 2018 S&P 500 EPS. So, if they pass the bare minimum of expectations, it’s likely worth about $5 in earnings, and that puts 2018 earnings at $143.

At 2400, and with $143 expected earnings, the S&P 500 is trading at 16.8X 2018 earnings. Again, that is high historically, but for this market anything sub 17X will elicit buying in equities (whether it should is an open question, but that is the reality).

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Weekly Market Cheat Sheet: May 8, 2017

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Weekly Market Cheat Sheet

Last Week in Review:

Economic data last week, highlighted by the strong jobs report, helped to somewhat narrow the gap between soft sentiment surveys and hard economic data… although it’s fair to say that gap remains open and is still a headwind on stocks, just a slightly less strong one. It was not all positive last week, though, as we got several signs of potential loss of momentum in China, which was an underreported but potentially important development last week. Finally, the Fed meeting proved to be a non-event, except in that it reaffirmed a June rate hike is likely (but that’s already mostly expected from the markets).

Starting with the jobs report, it met our “just right” scenario. The overall job adds were strong at 211k vs. (E) 185k, but revisions to the March report were negative 19k, so the net number was more in line. The unemployment rate dropped to 4.4%, but that was in part due to a decline in the participation rate. Meanwhile, year-over-year wage increases declined to 2.5% from 2.7%. Bottom line, this number was “fine,” but it wasn’t massively reflationary (in part due to the wage number) and that’s why we didn’t see the strong headline jobs report ignite an immediate reflation rally in stocks (again, the wage number undermined the strong job adds).

Looking at other economic data last week, there were more positives than negatives, highlighted by the ISM Non-Manufacturing PMI, which hit 57.5 vs. (E) 55.8. That strong Non-Manufacturing PMI helped to offset the soft April Manufacturing PMI, which dipped to 54.8 vs. (E) 56.5 while the New Order component dropped below 60 for the first time in five months. While disappointing vs. expectations, it’s important to remember that the absolute level activity remains strong.

Turning to the Fed, the key takeaway from last week’s Fed meeting was that the Fed viewed the loss of economic momentum in Q1 as “transitory,” and still said risks to growth were “roughly balanced.” Both terms are Fed speak for, “We’re going to hike in June despite the soft Q1 GDP.” The market largely expects that (Fed Fund futures have a hike priced at 83% (which is close to a universal conclusion).

Finally, I want to take a moment and focus on Chinese economic data from last week, as the numbers were universally disappointing. Official April Manufacturing PMI dropped to 51.2 vs. (E) 51.7 while composite PMI declined to 51.2 vs. previous 52.1. Additionally, iron ore went into quasi freefall this week, as iron ore futures ended limit down on the Dalian Commodities Exchange on Wednesday night. The drop came after the Chinese steel industry PMI dropped below 50, signaling contraction. Oversupply has something to do with the price drop as well (exports are surging out of Australia) but the bottom line is that base metal prices are a coincident indicator of economic activity. The declines in iron ore, steel and copper last week, combined with the under-whelming Chinese data, definitely caught our attention. We now are officially watching this closely for everyone, and will keep you updated.

This Week’s Cheat Sheet:

This week, April CPI and April Retail Sales (both Friday) are the important reports to watch. The latter is more important for markets at this point than the former, as we need to see a rebound from Q1’s paltry consumer spending. If retail sales fail to show progress and beat expectations, it’ll widen the gap between soft data and hard economic numbers. With CPI, we should see some mild cooling of the recent uptick in inflation, but overall inflation pressures continue to slowly build.

Outside of those two numbers, focus will be on the Chinese CPI and PPI, as again data there suddenly turned lower last week. Bottom line, it should be a quiet week, but retail sales and CPI are important as the “gap” between soft sentiment surveys and hard economic data remains… and it needs to close further if we are going to see a breakout in stocks.

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Jobs Report Preview, May 5, 2017

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For the first time in 2017, the risks to tomorrow’s jobs report are balanced, as a “Too Hot” number will increase the possibility of more than three rate hikes in 2017 while a “Too Cold” number will fan worries about the pace of economic growth, and the ability for better economic growth to push stocks materially higher.

Here’s The Sevens Report traditional “Goldilocks” breakdown:

“Too Hot” Scenario (Potential for More than Three Rate Hikes in 2017)

  • >250k Job Adds, < 4.6% Unemployment, > 2.9% YOY wage increase. A number this hot would likely reignite the debate over whether the Fed will hike more than three times this year.
  • Likely Market Reaction: Withheld for subscribers. Unlock with a free trial at 7sReport.com.

“Just Right” Scenario (A June Rate Hike Becomes More Expected, But the Total Number of Expected Hikes Stays at Three)

  • 125k–250k Job Adds, > 4.7% Unemployment Rate, 2.5%-2.8% YOY wage increase. This is the best-case scenario for stocks, as it would imply still-stable job growth, but not materially increase the chances for more than three rate hikes in 2017.
  • Likely Market Reaction: Withheld for subscribers. Unlock with a free trial at 7sReport.com.

“Too Cold” Scenario (A June Rate Hike Becomes in Doubt)

  • < 125k Job Adds. Given the recent unimpressive economic reports, a soft jobs number could cause a decent sell-off in equities. As the Washington policy outlook continues to dim, economic data needs to do more heavy lifting to support stocks. So, given the market’s focus on future growth, the bottom line is bad economic data still isn’t good for stocks.
  • Likely Market Reaction: Withheld for subscribers. Unlock with a free trial at 7sReport.com.

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This Week’s Fed Decision Takeaway and Rate Hikes To Come, May 4, 2017

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The Fed made no changes to interest rates this week, as expected.

Fed Decision Takeaway

The Fed statement almost perfectly met our “Meets Expectations If” scenario, as the Fed acknowledged the slight loss of economic momentum since March, but stated it viewed the slowing as only temporary, and left the door firmly open for a rate hike in June.

Looking specifically at the statement, the Fed said yesterday that economic activity had “slowed” compared to “expanded at a moderate pace” in March. But, in the second paragraph, the Fed said the loss of economic momentum appears to be “transitory,” and signaled the recent underwhelming data won’t make the Fed deviate from future rate hikes.

Underscoring that point was the fact that the Fed said risks to the near-term economic outlook continue to be “roughly balanced,” which is Fed speak for “we can hike rates at any meeting going forward.” Bottom line, the Fed was not spooked by the recent soft data and it is not deterring them from any future rate hikes… yet.

From a market standpoint, there was a mild “hawkish” reaction, not so much because the statement was hawkish, but instead because there was nothing dovish in the statement. That’s what markets have become conditioned to expect. The Dollar Index drifted to the highs of the day 30 minutes after the statement while the 30-year Treasury erased small gains and closed fractionally lower. Stocks drifted slightly lower, but selling was mild. Overall, the Fed statement was not a market mover.

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Tom Essaye on “The Bell” Podcast with Paul Sweeney and Adam Johnson

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Bullseye Brief with Adam Johnson, Paul Sweeney and Tom Essaye

I was a guest on Adam Johnson’s podcast “The Bell” last week. We talk with Paul Sweeney of Bloomberg Intelligence, “the man who’s turning Wall Street research upside down”. There are big changes in the research industry and Sweeney is on the leading edge of those changes. We also talk about “Animal Spirits” vs Hard Economic Data, Earnings and Employment, Mortgages being back under 4% here in Fed Week.

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Another Oil Plunge, Futures Down, May 3, 2017

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Oil futures sank 2.74% yesterday, with a large portion of the losses coming in the final hour. The catalyst for the decline was a collection of analysts’ estimates for this morning’s EIA report that started to come in showing more substantial builds in product inventories even though oil stocks are supposed to fall.

RBOB gasoline futures have been leading the way lower since they topped out on April 12. In fact, since that day, futures have only notched one single gain (that is three weeks with just one positive trading day). Gasoline futures now are within 3% of their 2017 lows, and if the downtrend continues that will be a headwind on the rest of the energy space.

Oil futures came within 1% of their 2017 lows yesterday and the momentum is clearly with the bears. Yesterday’s move was amplified by a “stop run” as futures broke through the March lows in the June contract. But in an encouraging sign of weakness, futures were unable to rebound.

On the charts, futures broke through a longstanding technical uptrend line that dated back to early August. That is another sign of technical weakness in the market.

In doing some cross-asset analysis yesterday, there was evidence that the inverse correlation between oil prices and long bond prices is resurfacing. As a reminder, for a period of time back in early 2016, long bond futures were trading almost exclusively off of the price of oil (specifically when WTI had a $20 handle). The reasons were twofold.

First, low oil prices are a drag on inflation readings, which would have dovish implications for Fed policy (long bond positive). Second, long bonds benefited from a safe-haven/fear bid as lower oil prices increased the risk of small producers defaulting on loans, many of which were issued by southern and central regional banks. Ultimately, contagion fears weighed on regional banks and the broader financial sector collectively. Now, it is not clear whether this is happening again as it was only one day of trading so far, but it is something to keep in mind going forward. If oil declines cause a sharp break lower in longer-term interest rates, that will weigh on stocks.

Bottom line, the fundamentals (rising US production and still-overflowing global stockpiles), technicals (new five-week lows), and market internals (bearish term structure) all continue to favor the oil bears right now, and the idea that we are in a “lower for longer” price environment still stands.

Oil and the rest of the energy complex is, however, near-term oversold, and we could see a volatile short covering rally given the right catalyst. Such a move would likely be short-lived, and if we were to see a continued move into the low $40s or even high $30s that would have serious implications for all asset classes (as in early 2016).

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FOMC Preview and the Next Rate Hike, May 2, 2017

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There is virtually no chance the Fed will hike rates at tomorrow’s meeting, as the chances were slim before the recently disappointing economic data. Now, those chances have declined to near zero. The key question tomorrow is: Just how forcefully will the Fed telegraph the next rate hike?

The answer to that question, taken in the important context of the recent slowing of economic momentum, will decide whether the FOMC decision pushes stocks higher, or whether we see a retracement of the recent gains.

May FOMC Meeting Preview + Next Rate Hikes

Hawkish If: The Fed clearly signals a rate hike is coming in June. Right now, Fed fund futures are pricing in about a 70% chance the Fed does hike rates, but that’s not a consensus expectation, yet. If the Fed specifically points to the “next” meeting in tomorrow’s statement (as it did in the fall of 2015 and 2016) as the likely date of the next rate increase, you will see markets react hawkishly as a June rate hike is not a foregone conclusion. Additionally, if the Fed is still intent on hiking rates in June despite recent economic data disappointments, that might imply a Fed that is more hawkish than previously expected.

Likely Market Reaction: Withheld for subscribers. Unlock with a free two-week trial of The Sevens Report.

Meets Expectations If: The Fed slightly downgrades the assessment of the economy in paragraphs one and two, but also says any slowing of activity is likely only temporary (it’s the temporary part that is the key). Markets expect the Fed to acknowledge the modest loss of economic momentum, but not to make too big a deal out of it.

Likely Market Reaction: Withheld for subscribers. Unlock with a free two-week trial of The Sevens Report.

Dovish If: The Fed materially downgrades economic commentary in paragraph one and downgrades the outlook on inflation, and in doing so materially reduces the chances for a June rate hike. Specifically, to be dovish we would need to see 1) A downgrade of both the growth and inflation language in paragraph one, plus no mention of it being temporary. The net effect would be to remove the expectation for a June rate hike.

Likely Market Reaction: Withheld for subscribers. Unlock with a free two-week trial of The Sevens Report.

Wildcard to Watch

Fed Balance Sheet. As we have covered, the reduction of the Fed’s balance sheet is an important but under reported topic that could result in a more-hawkish-than-anticipated Fed. Specifically, the major questions facing the Fed regarding the balance sheet are:

1) When will the Fed begin to reduce the balance sheet (2017 or 2018)?

2) What securities will the Fed stop buying (just Treasuries or Mortgage Backed Securities, too)?

3) How will the Fed stop reinvesting proceeds (all at once, or gradually)?

How these questions are answered will determine whether the Fed balance sheet is a hawkish influence on markets (yields up, stocks potentially down).

I (and almost everyone else) do not expect the Fed to touch on this in this week’s meeting. However, if the Fed does address this topic, it will come in paragraph five of the statement. Any change there will likely have hawkish implications on markets tomorrow, but again any changes are unlikely.

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Last Week and This Week in Economics, May 1, 2017

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Economic data continued to underwhelm last week and the gap between soft sentiment surveys and actual, hard economic data remains wide, and that gap remains a medium term risk on the markets.

The Sevens Report - This week and last week

Last week in Economics – 4.24.17

Looking at the headliner from last week, Q1 GDP, it was underwhelming, as expected. Headline GDP was just 0.7% vs. (E) 1.1%, and consumer spending (known as Personal Consumption Expenditures or PCE) rose a mea-sly 0.3%. But, the 0.7% headline met the soft whisper number and that’s why stocks didn’t fall hard on Friday.

That GDP report came on the heels of another underwhelming Durable Goods number. The headline missed estimates but the more importantly, New Orders for Non-Defense Capital Goods ex-Aircraft rose just 0.2% vs. (E) 0.4%, although revisions to the February data were positive.

Meanwhile, inflation metrics firmed up last week. First, the PCE Price Index in Friday’s GDP report rose 2.2% vs. (E) 2.0%, while the Employment Cost Index, a quarterly gauge of compensation expenses, rose 0.8% in Q1 vs. (E) 0.4%. Those higher inflation readings were why you saw the dollar rally pre-open Friday despite the disappointing GDP report.

Bottom line, the economic data over the past several weeks hasn’t been “bad” and it’s not like anyone is worried about a recession. But, the pace of gains has clearly slowed, and until we see a resumption of the economic acceleration many analysts were expecting at the start of 2017, any material stock rally from here will not be economically or fundamentally supported (and remember, it was the turn in economic data back in August/September that ignited the late 2016 rally. Yes, the election helped, but the momentum was positive before that event, so economics do matter).

This Week in Economics – 5.1.17

Economic data this week could go a long way towards helping to resolve the large gap between soft sentiment surveys and hard economic data, given the large volume of economic reports looming this week.

First, it’s jobs week, so we get the ADP Employment Report on Wednesday and the official jobs report on Friday. We’ll do our typical “Goldilocks Jobs Report Preview” on Thursday, but after March’s disappointing jobs number, the risks to this report are more balanced (it could easily be too hot if the number is strong and there are positive revisions, or it could be too cold and further fuel worries about the pace of growth).

Second in importance this week is the Fed meeting on Wednesday. The reason this is second in importance is because it’s widely assumed the Fed won’t hike rates at this meeting (June is the next most likely date for a rate hike), although the Fed has turned slightly more hawkish so there’s always the possibility. We’ll send our FOMC Preview in Wednesday’s report but the wildcard for this meeting is whether the Fed gives us any more color into how it plans to reduce its balance sheet. If the Fed does reference or start to explain how its plans to reduce its balance sheet, that could be a hawkish surprise for markets.

Finally, we get the global manufacturing and composite PMIs this week. Most of Europe is closed today for May Day so just the US ISM Manufacturing PMI comes today, with the European and Japanese numbers out tomorrow. Then, on Wednesday, we get the US Service Sector PMI and global composite PMIs on Thursday. The global numbers should be fine but the focus will be on the US data. In March we saw a loss of positive momentum in these indices but the absolute levels of activity remained healthy. If we see more moderation and declines in the ISM Manufacturing and Non-Manufacturing PMIs in April, that will stoke worries about the overall pace of growth in the economy and that will be a headwind on stocks.

Bottom line, this a pretty pivotal week for the markets. On one hand, if economic data is strong and the Fed a non-event, the S&P 500 could push and potentially break-through 2400. Conversely, if economic data is underwhelming and the Fed mildly hawkish, we could easily see last week’s earnings/French election rally given back, and the S&P 500 could fall back into the middle of the 2300-2400 two months long trading range.

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Political Update for Investors, April 27, 2017

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Political Update for Investors

Trading yesterday was driven by multiple political-related headlines. Politics reasserted itself on the market narrative on Wednesday, helping stocks initially rally following renewed hopes for an Obamacare repeal/replace bill, and after the Trump Administration unveiled a significant (though expected) tax cut plan.

Yet despite the media focus on those two events, any actual progress with healthcare or taxes remains unlikely (and didn’t get better yesterday). The third piece of political news, an investigation into aluminum imports by the Commerce Department, was the most important (yet underfollowed) political development for markets yesterday.

I cover each issue below, cut through the noise, and get to any likely market influence. The bottom line is that despite generally favorable headlines, all the political news yesterday was a mild net negative for stocks.

Trump Administration Tax Cut Plan.

What Happened: The Trump Administration unveiled a sweeping tax cut proposal that included a 15% corporate rate, just three individual tax brackets, doubling the standard deduction, and repatriating overseas profits.

Why It Matters: Corporate tax cuts remain the easiest catalyst for a stock breakout, but unfortunately the tax plan revealed yesterday is very unlikely to pass Congress, and the reason is simple: There is no offset to the reduced revenue from lower taxes. As such, this plan will increase the deficit, and that likely means Democrats can filibuster the bill. Going forward, unless a tax plan contains some material offsets to reduced taxes (like border adjustments) then passage of any big tax cuts remains unlikely in 2017, and that’s stock negative.

How Markets Reacted: Tax-related headlines can still cause a pop in markets, but only a credible plan that can pass Congress will be a bullish gamechanger. (For more market insights in your inbox by 7am each morning, sign up for a free 2-week trial at 7sReport.com.)

Healthcare Bill (Obamacare repeal/replace).

What Happened: The details were fast and furious on this yesterday, but as of this writing it appears the House will vote on the bill potentially this weekend, and odds of passing are decent.

Why It Matters: Passage of an Obamacare repeal/replace increases the chances of tax cuts also passing, as it will increase Trump’s political capital and provide more revenue to offset tax cuts. However, even if this bill passes the House, the chances of passage in the Senate in the current form remain slim. So, while a potential moral victory, it won’t significantly increase the chance of healthcare reform, and as such I don’t see it as a bearish gamechanger for healthcare ETFs (XLV, IHF, IBB).

How Markets Reacted: Stocks (including health care names) largely ignored this news, as again the likelihood of any Obamacare repeal/replace becoming law remains slim. (For more market insights in your inbox by 7am each morning, sign up for a free 2-week trial at 7sReport.com.)

Tariffs and Trade.

What Happened: Yesterday the Commerce Department announced an investigation into aluminum imports. No tariffs were announced, but it certainly looks to be moving in that direction. This announcement comes one day after Commerce levied taxes on Canadian soft lumber imports. Additionally, a Politico story hit midmorning that President Trump was close to signing a document notifying Mexico and Canada that the US intends to withdraw from NAFTA within six months. The document does not guarantee a US exit (they can change course), but it is a necessary legal step to begin the process. Since yesterday the White House has said it’s not preparing this document yet but didn’t squash the idea all together.

Why It Matters: These trade events yesterday (and this week) are actually the most important political events of the week, not because of their immediate impact (Canadian lumber and aluminum tariffs don’t mean a trade war, and the NAFTA announcement is likely for negotiating leverage), but it does remind markets of Trump’s potentially disruptive trade policies. That matters, because right now markets have not priced in any trade-related headwinds, so this does represent at least a modest risk to the bullish narrative.

How Markets Reacted: All the trade headlines weighed slightly on stocks during the late afternoon, but the current headlines simply aren’t bad enough to warrant an outright reversal in stocks. (For more market insights in your inbox by 7am each morning, sign up for a free 2-week trial at 7sReport.com.)

Bottom Line on the Political Update for Investors:

Material “gaps” remain that must be filled if the S&P 500 can sustain a meaningful breakout above 2400, including 1) The gap between political expectations and political reality, 2) The gap between too-low Treasury yields and very high stock prices (although that’s narrowed some-what this week, but not enough), and 3) The gap between soft economic surveys and hard economic data.

In the very short term, investor sentiment seems skeptical, and the market acts as though investors are more afraid of missing a breakout than they are a break down (similar to what we saw when the S&P 500 broke through 2300). So, the “pain trade” looks higher short term and that’s helping stocks.

But given valuations (the S&P 500 trading nearly 18X 2018 earnings), I don’t think sentiment alone is enough to push us decidedly through 2400 without positive resolution on some of these gaps. That means we need 1) Actual progress on tax cuts (which didn’t happen yesterday), 2) A rally in the 10 year above 2.40%, or 3) Better economic data starting today.

I am therefore sticking with my call that the 2300-2400 broad trading range in the S&P 500 should hold, and I would not be chasing stocks at these levels.

Cut through the noise and understand what’s truly driving markets, as this new political and economic reality evolves. The Sevens Report is the daily market cheat sheet our subscribers use to keep up on markets, seize opportunities, avoid risks and get more assets.