From Nick Colas of Convergex [21] [21]
Just when you think the selloff couldn’t get any scarier, it did. The last hour of trading took over 1% out of the S&P 500 in rapid fashion, reportedly on fears of an Ebola check at a major U.S. airport. Today we offer up a “Top 10” list of specific markets and indicators to watch for signs of a near term market bottom. They include the CBOE VIX Index (key levels at 26 and 32), the action in small cap stocks and crude oil, and the dollar. Less quantifiable issues – but important nonetheless – are headlines related to Ebola (probably getting worse before better), 10-year Treasury bond yields (2.0% and 1.5% possible here), and European policymakers addressing a host of difficult monetary and fiscal policy issues. Bottom line: this is unlikely to be a dramatic “V-bottom” low given the range of issues of concern to investors. Look for the majority of our “Top 10” to stop going down before calling a bottom.
“Too late to sell, too early to buy”. That old market aphorism captures the current state of play in U.S. equity markets and to a great extent stocks around the world. Today’s selloff, on a supposedly light volume half-holiday with U.S. bond markets closed, felt like a brick thrown through a window at about 3pm. Those with a technical inclination to their analysis don’t like the fact that the S&P closed below its 200 day moving average of 1905. Fundamentally oriented investors wonder how stocks could implode when they are so “Cheap”. Safe to say: no one is happy.
Another bit of market wisdom, told to me by the smartest (and richest) boss I have ever had: “Don’t make things harder than they have to be.” That statement is the essence of good trading: listen to the market, respect what it has to say, and position capital accordingly. Investing, by contrast, is a bit of a hair shirt and ashy smudges on the face endeavor. Investors know they will feel some pain when things go against them. They stick with their positions and hope/expect them to prove correct. Traders know that that if they are feeling pain, something has gone wrong.
Right now, the discipline of the trader beats the faith based approach required of the investor, so let’s go with that. And hair shirts make me itch. “Sit tight, be right” is for analysts. And bull markets.
Here’s a checklist of ten items that I’ll be watching to tell me when the bulk of the selling is over. Yes, that implies we haven’t hit bottom. Does Monday’s price action feel like a bottom to you?
1. The CBOE VIX Index. Yes, the VIX gets its share of criticism, but in rapidly moving markets it has its place in the toolbox. The long term average – back to 1990 – is 20 and the standard deviation around that mean is 6. That means at 26 and 32 you have 2 reasonable levels where the VIX should top out. Now, if you think we are entering a period of real crisis, the numbers shift higher. Typically the VIX averages 28 when things are really bad (think back to the Financial Crisis) and the standard deviation rises to 8. That puts the target at 36 and 44.
Bottom line: don’t try to pick a bottom until the VIX gets to at least 26. It closed at 24.6 today. If you aren’t especially brave, then wait until 32-34.
2. U.S. Treasury Bond yields. The U.S. Treasury 10 year yield has been signaling trouble for stocks over much of this year. We began 2014 at 3.03%, and there hasn’t been a day this year where yields traded higher than that. For a while, equity markets treated bonds as the “Boy that cried global recession” once too often. Now, persistently low yields feel pretty right.
Where might yields go to signal that near term negativity is overdone? Well, the all-time low in yields for the 10 year was 1.5% back in July 2012. Getting back there seems a stretch, so as a practical point we’d say investors will want to see yields start to rise (from whatever starting point they choose) before they believe stocks have bottomed.
3. Small cap U.S. stocks stabilize. There is little doubt that the U.S. economy is in a marginally better position than Europe or Japan, but the Russell 2000 is down 10% on the year and meaningfully lower than the S&P 500 since the start of 2011: 34% versus 49%. All that signals both a reluctance to take risk (small caps being more volatile than larger names) and some squeamishness to allocate capital to equities with all-or-most of their business from the supposedly stronger U.S. economy.
The bottom line is simple: small caps need to show better performance to give investors confidence that we have made a bottom in large caps. Enough of the divergence – both asset classes have to start acting more consistently with respect to their common fundamentals.
4. Follow the ETF money. Equity money flows into U.S. listed exchange traded funds have been quite disappointing thus far in October, at negative $5.7 billion. By contrast, fixed income money flows are positive $8.2 billion. ETFs alone cannot lift equities higher, but you will want to see money flowing into this space before you ring the all-clear on the recent pullback.
5. Crude oil prices. Just as Treasuries gave us a warning sign that things weren’t quite right with the world, current levels for West Texas Intermediate at $85 are a flashing yellow light as well. Yes, there are a host of secular reasons for lower oil prices – Saudi Arabia pumping more, the U.S. producing more, etc. But oil prices are the blood pressure readings of the global economy, and the correlation is positive – not negative. So oil needs to stabilize, somewhere. The $80/barrel level is a good one to watch, as the commodity got there in 2011 and 2012.
6. Any Positive Headlines from Europe. Between all the news about Ebola, ISIS, capital markets volatility and other more pressing concerns, it is easy to forget that Europe still has its hands full dealing with the threat of a third recession since the Financial Crisis. This region is still, one should remember, the largest single economy in the world. And yet… It has no solid plan for encouraging investment and growth. Remember when the Dow fell +700 points after Congress failed to pass the TARP bill the first time? The current market volatility may give European policymakers the same impetus.
7. The value of the dollar. The fashionable discussion here is whether a strong or weak dollar if better for stocks. We could argue either. The real issue is just how volatile the U.S. currency has been, even including today. In truth, what we need to see is a stable dollar at whatever level it chooses. That will be a sign of a bottom, in that investors will have set some kind of equilibrium from which they can begin to choose between different asset classes.
8. Higher volumes. Much higher. We do appear to have snapped the 5 year downtrend for U.S. equity volumes with the recent volatility. Look for trading volumes to continue to rise in the coming weeks. As will the dollar, oil, and small cap stock levels, whenever volumes plateau that will be a good place to call a bottom.
9. Hedge fund chatter. The current price churn is really good news for your garden-variety equity hedge fund because it changes the game they will play for the next few weeks. As a hedge fund, you typically want to make as much of a return as possible, since this drives fees and attracts new investors. In a down year – like the one we now have – the goal is to lose less than other hedge funds. That means cutting back the portfolio as markets decline to minimize risk of loss. Do it quickly, and you will lose less than the next guy.
While we don’t know which unlucky hedgie will actually do this trade, I can assure you that the bottom tick of the current pullback will be from some hedge fund letting go of their last favorite – but losing – stock position. So look for signs of distress in the hedge fund community – perhaps including chatter of a high-profile closure or two – as a signal that stocks have actually hit their low points.
10. Ebola, ISIS, and other risk factors. I saved these points for the last because they merit the final word on the topic of “When do we bottom?” If you believe ISIS will sweep the Middle East or Ebola is a large scale threat to human existence, you really shouldn’t be in equities. Or bonds. Gold, Glocks and canned food should be your thing. And there’s absolutely nothing wrong with that.
However, realize that the Middle East has been a mess longer than just the arrival of ISIS on the scene. And Ebola is just one more stanza in the sad song of diseases that kill innocent human life. For the moment, however, fear has the upper hand and we have to respect that. That’s why this list has 10 items, rather than just this last one. “Ebola cured” or “ISIS defeated” are not going to be headlines in 2014. Or likely in 2015 or 2016 for that matter. The other nine of our top 10 will have to deliver the signal that these larger worries are discounted in stock prices.
