Never Short a Dull Market

We can finally put the last two news rich weeks behind us. We have learned that Trump and Hillary will be the Presidential nominees. What we have also learned is that the ECB and the BOJ have fired their last volleys and going forward their respective monetary policies will stand pat for the time being possibly setting up policy reversals into tightening monetary policy for 2017. The FED on the other hand signaled a slightly more dovish rate increase path for the remainder of the year. I like how CNBC contributor Larry McDonald described these announcements this week:

“The Central Banks have literally taken the fire hose out and kept it on and I think that really shocked a lot of people. I think that is going to keep the VIX at bay for now”

I agree except the “shocked” part. After all Mandate #1 of Central Banks is to “keep prices stable”. And what that means for us is “reduce volatility”. So I am not sure why people are shocked that the FED and the other Central Banks are doing their job. As far as I am concerned this is just another day at work for them.

The cumulative effect of all these Central Bank announcements is the killing of the US Dollar rally. In what appears to be a coordinated efforts sanctioned by Europe, Japan and the US, the Central Banks have decided to put a lid on the US dollar strength.

That obviously has numerous inflationary repercussions. The reflation trade is back on – Oil is up, Gold is up, Gopper is up, High Yield debt is up, Emerging Markets are up and the end result of all of this is that the SPX is up as well. After all SPX earnings will no longer be hampered by a strong dollar and more importantly international earnings will start showing organic growth. Multiple wins here. Even Tim Cook can breathe easier now (that is if he can get the bulldogs at the FBI off his back). More importantly for us, the heightened volatility that was the hallmark of the 6 month period from August 2015 to February 2016 is now put to bed with definitive certainty for the next few months.

The SPX is up in the best possible fashion – featuring broad sector participation and increasing volume. Money is pouring into the lagging sectors of 2015 – utilities, transports, industrials, telecom, consumer staples, energy and materials. Financials, technology, health care and small caps are still trailing. But guess what? Eventually they will join the party as well. And the eventual sector rotation will result in continuous low volatility. 2012 redux.

Key Market Levels

This week featured a steady market melt-up. We have now crossed numerous very important technical thresholds – the 200 moving average, the Nov-Dec trendline, the 23 GAAP P/E level and we are now in what I call “price discovery” portion of the rally. Some people like Ralph Acampora call that a “vacuum” rally. This is a period of time when the market is trying to determine the price of the market. But unlike downturns where “price discovery” is sharp and abrupt and features a lot of volatility, “price discovery” during a market meltup is slow and steady. The multiples slowly expand until they reach levels that investors can’t tolerate anymore. But we are far from that point.

Based on the how long the Volatility Curve has been in contango and the VIX in a decay phase, we’re nowhere near the end of that trend. There are at least 2-3 weeks to go before we even get to a point where the volatility indicators start showing up on the “Volatility Streaks” report (in the Streak chart above the orange is the active streak). In other words as long as this rally has been, the “Decay” phase of the VIX cycle historically has a lot further to go.

The question here is how much will P/E multiples expand. As I mentioned before, we have now entered a 23-25 GAAP P/E level range. Now, I can’t tell you and nobody else can whether the multiple expansion will stop at 24, 25, 26, 27 or 28. Nobody knows that. The only reliable benchmark we have is the SPX Dividend Yield vs 10-Year Treasury Yield comparison. The current yield on the 10-Year Treasury is 1.88%. The SPX dividend yield is 2.12% with actual dividend at $43.46 (yes higher than before). If the two yields reach equilibrium we are looking at 2300 on the SPX and a roughly 26.75 GAAP P/E multiple. So from that perspective we still have a lot of room to run.

Resistance levels on the topside are looking at 2100-2120 where the Aug-Dec trendline sits and after that the all-time highs of 2135.

Support area is the 2000-2020 area whet the 200MA, 10MA and September Top sit.

Key Volatility Levels

The XIV had another good week with a 7.3% return. Now that the VIX has dropped below the key level of 16 which signifies a Low Volatility Regime we can actually calculate some targets for the XIV for the next couple of months. Assuming that the average VIX stays in the 14-15 range (let’s say 14.5) for the next two months and given the still relatively elevated VX1 and VX2 futures (compared to the remainder of the Volatility Curve), I have calculated that the XIV will reach 28 by mid-April and 34 by mid-May. The XIV is about to have some spectacular weeks should the VIX continue to stay in the 14-15 range.

There is a saying on the street – “Never Short a Dull Market”. With a news and earnings vacuum from here till mid-April we are looking at exactly that – a “Dull Market”. As a far as the XIV is concerned, the best gains for the XIV happen not during a Rally but in the Consolidative Phase after the Rally when volatility is low and the market drifts slowly higher with occasional 3-4 day consolidations. Like you well know, the Party is all well and good, but the magic happens in the After-Party. Same with the XIV.