In my article last week, I mentioned the VIX was at unusually low levels. Today the market fell and the VIX finally increased off its near record-low levels. The VIX was up 12.29% to 11.88. This is still relatively low, but it’s no longer extremely oversold. The media narrative was that stocks sold off today because of Trump’s immigration policies, but I think stocks fell because they were overbought and because of the negative news which came from Europe. The negative news was Unicredit, Italy’s largest bank, stated its new plan may not be approved by the ECB. Its phased-in Tier 1 ratio was at 8% at the end of 2016 which is below the ECB’s minimum of 8.75%. This caused the stock to fall 5.45% on the day.
Technically, no one knows why the market fell, but it’s easy to get caught up in American politics and miss the international financial news. The chart below shows the point I was making about the VIC in more depth. As you can see, the VIX is only below 11, 1.8% of the time since 1990. However, as I mentioned before, this on its own, is not a reason to be bearish on stocks. The four lowest closes in the history of the VIX were in 1993 which was a great time to buy stocks as it was prior to the 1990’s tech bubble.
The chart below shows this optimism/complacency many have and its relationship to market tops. Whenever the consumer confidence hits above 110, the average return per year in the Dow is 0.51%. This indicator provides more context for the VIX because it eliminates the current market being compared the 1993 because in 1993, the consumer was pessimistic. It was beginning its run higher. The low volatility didn’t signal euphoria like it is signaling now, in my opinion.
Adding to the euphoria is the expensive valuations. When the market has a price to sales ratio above 1.26, it increases an average of 1.30% per year. When looking at these three factors, I conclude that euphoria has never been higher. This means over the long term, stocks will underperform. This is what many investors who aren’t looking at historical precedent don’t understand. They think the market will correct 20% and rebound. They think because the market rebounded in 2009, that stocks always go up eventually. In the extremely long term, it is true that stocks move higher, but there have been decades of nothingness. Most people invest for retirement over a period of 20-30 years, so having no return for 10 years, cuts a big dent into potential savings. Keep that in mind, when some tells you to ignore valuations.
One group who isn’t as bullish on stocks is insiders. They are selling which is considered a bearish indicator. Those in the finance industry are selling in particularly large amounts. It makes you wonder what they know, that we may not know. Default rates increasing could easily wipe away any gains seen from increasing net interest margins and decreasing financial regulations.
Looking at the market objectively, I can’t understand why everyone is so positive. This has been the weakest recovery since 1949 and earnings haven’t been growing recently. There is some hype caused by Trump’s deregulation, but stocks were expensive before that. I wouldn’t have been surprised to see a Hillary rally given the market’s ignorance of fundamentals. The chart below shows the revenues of Dow companies excluding the oil firms. This shows since 2011, there has only been a 13% increase in revenues. The Dow is up 71% from the beginning of 2011 which shows the multiple expansion which has occurred.
The chart below shows the relationship between the earnings yield and the real returns in the S&P 500 over the subsequent 5 years. There has been a correlation between the earnings yield and returns. Currently the earnings yield is low and returns are high, so it means returns are about to come down.
Moving to the economy, another interesting relationship is convenience store sales to gas prices. When gas prices move higher, sales at convenience stores, excluding cigarettes, move lower. These convenience store sales mimic the cycles in the economy. With gas prices rising and convenience store sales slowing, it makes you wonder if we are in for another slowdown like 2012 or like the major recession in 2008. Considering there’s usually one mid-cycle slowdown, I’m expecting the latter.
The final chart slows the relationship between oil and stocks. As you can see, not only do high oil prices hurt consumption, but it also causes the S&P 500’s price to earnings multiple to fall. This may have had a higher impact than usual on the market in the last cycle because oil went to $147, but it is an interesting factor to keep in mind.
As I’ve said previously, I’m expecting oil prices to fall in the future. However, just because I’m bearish doesn’t mean I don’t recognize variant possibilities. I even recognize that equities can move higher even though I can explain a myriad of different reasons why they shouldn’t. If oil rises significantly, it will be bad for the economy and if oil falls, it’s bad for energy firms’ earnings. The bull case for stocks is if oil stays range bound and isn’t volatile.
Conclusion
The VIX is low, consumer sentiment is high, the market is expensive, and insiders are selling. This is not a recipe for higher stock prices, but I’ve been wrong before. Even though GDP grew 1.6% last year, that was above my expectations. I recognize that there needs to be a major catalyst to knock this market down. Given the economy hasn’t had a sharp leg down, and likely won’t soon because of the business optimism caused by the Trump administration, we may be waiting for this overvaluation to subside for even longer.
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