"May you live in interesting times'” is reported as being of ancient Chinese origin, but is neither Chinese nor ancient. Rather, it is recent and Western. Regardless, while purporting to be a blessing, the saying actually implies a curse - the expression is used ironically, with the implication that ‘uninteresting times', of peace and tranquility, are more life-enhancing than ‘interesting’ ones. The quarter ended more-or-less flat, with the S&P 500 Index up 0.6%. The third quarter (Q3) was marked by low volatility, with the VIX (S&P 500 Volatility Index), a tool used to measure volatility of the overall market, continuing to exhibit near historic lows.
Volatility, like most things in the market, tends to display price patterns. The summer months often demonstrate lower levels of volatility. However, as I am sure many of you have noted, there has been a pickup in volatility over the past week. What do historical seasonal patterns tell us about volatility as we move into October? And what are market valuations currently implying?
As mentioned, volatility has historically exhibited strong seasonal patterns. As you can see from the chart below, the current year’s volatility cycle (red line) is tracking closely to the historical norm (blue line). (Please note this chart is a couple of months out of date.) And if history repeats itself, we may continue to see increased volatility over the coming weeks (see peaking of volatility in late October/early November.)
Opportunity may accompany volatility – if you are an active money manager, and have taken profits, and are holding cash to buy securities at lower levels. However, if you are a 'buy and hold' investor – with no 'sell discipline' – volatility may result in some sleepless nights.
As a money manager, I am always striving to assess the potential 'risk versus reward' of individual securities and the market as a whole - that is, how much upside potential is there compared to the risk of loss. While I primarily use technical, tape-based indicators – that is, I use computer models to assess whether price action is positive, neutral, or negative – this does not help much in determining 'risk versus reward.'
There are certainly many other tools at my disposal - investor sentiment, P/E ratios, interest rate levels, etc. But what’s particularly challenging, is that we are not living in 'normal times.'
If one looks at P/E ratios, per the chart below which shows a compilation of a four valuation metrics, US stock indices are significantly overvalued, which suggests cautious expectations on investment returns – that is, lower reward and higher risk. In a 'normal' market environment – one with normal business cycles, Federal Reserve policy, interest rates and inflation – current valuation levels may be a serious concern.
Financial Crisis largely shaped the current economic cycle. In 2007, with the collapse of Bear Stearns' funds, the Fed began its march towards Zero Interest Rate Policy (ZIRP), cutting interest rates to where they stand today – at near historic lows.
A recent post by Doug Short provided some perspective: "Since the Financial Crisis, we have essentially been in uncharted territory. Never before have we had such high P/E ratios with yields below 2.5%. (The latest monthly average of daily closes on the 10-year Treasury bond yield is at 2.53%, which is well above its low of 1.53% in July 2012.) In all of US history, the closest we came to this was a seven-month period from October 1936 to April 1937. During that timeframe the 10-year Bond yield averaged 2.67%. How did the market fare? In looking at the Dow Jones Industrial Average daily closes during that period, the index hit an interim high on March 3, 1937 and then fell 49.1% to an interim trough on March 31, 1938 – 13 months later."
Despite the tapering of Quantitative Easing, many are assuming that Fed will keep yields low for a prolonged period. Individuals – particularly those who are retired – need income or growth in their investible assets to support their financial needs. With fixed income instruments yielding so little, many investors are buying stock as a way to fund these needs. In other words, ZIRP is motivating investors to disregard historic indicators that warn of an overvalued market, just so they can 'put their money to work.' This, of course, is a concern as investors may be chasing returns, only considering upside returns, with little regard to managing risk and minimizing losses – and the latter is a primary and critical component to building wealth.
So, while P/E valuations are elevated by historical standards, this type of investor behavior may be able to push markets higher – beyond what is reasonable. On the other hand, we could see a negative market reaction to a growing sense that Fed intervention may have its downside, resulting in an increased inflation/deflation risk.
Regardless of the underlying fundamentals (P/E ratios, inflation levels, interest rate levels, etc.), our tape-based approach strives to help guide us on what the market is doing, rather than what we think it should be doing.
We are indeed living in interesting times. Stay vigilant!
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