E Bullish? Bearish? It's Perplexing, Says The VIX

Now that's how you bounce back from a sharp decline in the previous week. And why did markets bounce back this past trading week; markets made it so. When it was all said and done for the trading week, the S&P 500 (SPX) bounced back strongly, ending Friday up 2.79% from the previous Friday.

We're coming into the tail-end of the trading year and still with the S&P 500 up nearly 17%, but having a rough August for which many are glad to see it go. The only 2 years to be positive each of the first 8 months except May and August were 1967 and, of course, 2019. Here's what happened next in 1967:

Kind of mediocre if you ask us! But remember, the S&P 500 is up at least +10% YTD thru August and the sample size is worthless. So what do you think the market is likely to do in the final months of the trading year? Again, we can review history as a means of satisfying probabilities even if history doesn't necessarily have to or always repeat. (Table from OddStats)

History invites us to expect bullish outcomes for the remainder of the trading year, but history did not have 2 of the world's largest economic powers feuding and throwing tariffs back and forth for over 12 months. In being grateful that August is in the rear view mirror, let's not count our chickens...Over the past month, we’ve not only seen the worst 3 days of the year, but many 1% swings in both directions with the VIX up nearly 18% in August.

The good news is August is finally done and while the S&P 500 lost 1.81% during the month of August, September may bring better returns and a more complacent market. Not so fast! Since 1950, September has been the worst month for the S&P 500 Index, which has dropped an average about 0.5% during the month. September’s track record has been a little better recently though: Over the past 10 years, the S&P 500 has averaged a 0.9% gain in September.

“August was a burst of volatility for most investors, and we expect that to continue in September,” explained LPL Financial Senior Market Strategist Ryan Detrick. “But if you’re looking for some good news, the past 15 times stocks were lower in August, the rest of the year was actually higher every single time.”

We'll have to see if history is an accurate guide for 2019 and post the August decline, especially with the ongoing trade feud. And least we not forget the No-Deal Brexit situation that has not presented itself in the historic data. Maybe this time is one of those times we should desire this time to be different, indeed?

The August dump didn't have to happen, but the late July tariff escalations forced investors to reconsider their equity market exposure. Nonetheless, seasonality played its role and history proved to repeat the August dump. With that being said, if the seasonal patterns hold, there is an upward bias into mid-September for stocks, then a 2nd dump into October. The market is keeping equity investors on their toes in 2019 for sure. (From @AlmanacTrader)

In analyzing why the market performed as it did this past trading week, rising nearly 2.8% on the week, we're forced to review something I stated in last week's Research Report. Recall below:

With that being said, markets dictate policy and eventually the market will arise to the occasion once again. That may already be why the President’s tone on trade is seemingly more conciliatory than it was during Friday’s tweet storm.

After the prior Friday tweet storm and greater than 2.4% down day in the equity markets, the Trump Administration changed its general tone on trade issues with China. Weekend Equity betting futures in London were identifying a sharp decline for this past Monday's open on Wall Street and with leaders at the G-7 Summit wrapping up a long weekend.

Once POTUS recognized the markets reaction to the trade rhetoric, it was offered that high level calls were taking place with the Chinese trade delegates and the markets quickly reversed losses and found themselves moving sharply higher. To reiterate, "markets dictate policy, always!"

While nothing actually changed for the better, with respect to geopolitical tensions, markets looked past the present escalations and toward more concrete issues. Bond yields have been plaguing investor and equity sentiment for much of the Q3 period. While much of the U.S. economic data has continued to point in favor of trend-growth (1.7%-2.5% GDP), the bond market has been suggesting something far worse is on the near-term horizon. Wether or not that "something far worse" comes to pass or not remains to be seen, but the unintended consequences from bond yields plunging as Treasury prices soar has been a boon for equities in the final trading week of August.

In this week's State of the Markets video, Finom Group (for who I am employed) outlined the need for pension funds to rebalance at the end of the month in August. The "risk free rate" is an important concept when it comes to pension funds and how they project returns and allocate capital.

  • A growing number of public pension plans are recognizing the impact of a low-rate and low-return environment, by reducing their expected return assumptions. This chart from the 2019 NASRA Public Fund Survey shows the evolution of expected return assumptions for public pension plans. In 2019, the median expected return was 7.25% across the largest public pension plans based on their diversified asset mix. This is much lower than in 2001, when most public plans had expected returns greater than 8%. The number of plans with expected returns below 7% has gone up from zero to 16 in that same time.

  • Achieving a 7.5% return when interest rates are low to negative is riskier than achieving the same return in a higher-rate environment. For example, if risk-free interest rates are at 5.5%, then a pension plan needs to take only enough risk to generate an additional 2% in return. However, if the risk-free rate falls to 2%, then a pension plan needs to take significantly more risk in order to generate the additional 5.5%. Taken to the extreme, if interest rates were to go to zero, then the entire 7.5% would be subject to risk.

Let’s review current conditions in a “risk-free” Treasury. The benchmark 10-year Treasury current yield is a mere 1.50%, as of yesterday’s close (Aug. 30). That’s close to an all-time low, which actually occurred during the Brexit vote of 2016 at 1.32 percent. Can you do better with a broader set of assets? Perhaps, although “better” is a relative term and one that requires adjustment for risk. That sentence says it all and why we recognized billions of dollars worth of pension fund capital rotating out of bonds and into equities. In fact at present, the S&P 500 dividend yield is now higher than that of the 30-year bond. Pension funds don't have a choice. If they want to hit their projected return targets for the year, they have to move out on the risk curve i.e. allocate capital to riskier assets, like equities and/or equity ETFs. This doesn't detract from the point that bonds are extremely overbought. (See chart below)

Only 3 times dating back to 1962 have we seen such oversold yield conditions on the weekly relative strength index (RSI) for the bond yields (TNX).

The sample size is extremely small, but that should be the expectation given the extreme oversold yield conditions we're seeing in the present and with record high bond prices. Nonetheless, in the 2 anecdotal cases presented from 1986 and 1998, bond yields rallied along with stocks across almost all time frames 2 years out. 

With all that being said, some good things did happen last week even as August found negative returns. The NYSE A/D line hit a new high, breaking out of a recent channel. What is the significance you might be asking yourself?

While it's true that the A-D line has often weakened before stocks have encountered a major decline, you'll need hindsight to make use of this information because you won't know it was a leading indicator until after the market weakens. For every time a weakening A-D line has signaled a major fall it has signaled nothing special at least twice as often. "Negative divergences" happen all the time.  In real-time, it is impossible to know when a divergence is worth paying attention.

Last week, the cumulative advance-decline (A-D) line for both the NYSE and the S&P 500 made a new all-time high. The A-D line sums the net number of stocks moving up on the day added to yesterday's total.  The idea is that when the A-D line is rising, more stocks are moving higher and breadth is considered healthy. In other words, it's a bullish sign for stocks. The not so great news is that the gains for stocks haven't always occurred right away. The S&P 500 went nowhere for several months in 2016. That was also the case in 1993 and 1996, for example. Nonetheless, the breakout to a new high in the A-D line while the S&P 500 is still below its own ATH looks bullish. But there's more, take a look at the following chart of the S&P 500 and moving averages within their respective clusters and during consolidation periods:

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