What's Driving this Complacency?

05/15/2017 2:50 am EST

Focus: STRATEGIES

Matthew Kerkhoff

Editor, Dow Theory Letters

The S&P 500 and Nasdaq closed at new all-time highs, while the volatility index (also known as the fear gauge) remains near multi-decade lows; what's driving this complacency, asks Matt Kerkoff, technical expert and editor of Dow Theory Letters.

Dennis DeBusschere, an analyst over at Evercore ISI, put together this chart comparing historical S&P valuations (vertical axis) against volatility (horizontal axis).

chart 1

As you can see, the current setup in the market is very unusual, approaching previous extremes in terms of a richly valued but low expected-volatility market.

So what’s causing the market to trade at historically high valuation levels with so little concern for risk? There are a couple of plausible explanations.

First, some have made the case that investors are beginning to protect their portfolios in different ways. Instead of buying S&P 500 puts, for example, some are turning to buying calls on longer-dated U.S. Treasuries.

The thinking here is that if stock prices do plummet, investors are likely to rotate into bonds, pushing yields lower and bond prices higher. Since longer-dated bonds typically have the highest duration (their prices react more sensitively to changes in interest rates), these calls can pay off handsomely.

The other situation that may be contributing to this odd occurrence has to do with either a “Trump put” or an “earnings put.” The former Greenspan put eventually morphed into the Bernanke put and finally, the Yellen put.

So have new market “puts” taken the place of previous ones? It’s possible, and I’ll make the case for two: an earnings put and a Trump put.

First earnings. So far, with 83% of companies in the S&P 500 having reported, the Q1 blended earnings growth rate is 13.5% (according to FactSet). This is substantially higher than the 9.0% growth initially expected.

That’s good news for a few months ago, but means very little as of today. Investors don’t care where earnings were -- they care where they’re headed. And right now analysts are actually expecting earnings to hold up for the rest of 2017.

But if earnings don’t continue to match or beat these expectations, this pillar of strength could crumble, leading to a decline in valuations and a rise in volatility.

The other “put” that may be casually sitting beneath the market has to do with Trump’s agenda. While we don’t know what to expect in terms of policy changes, most market participants acknowledge that this administration is trying to be much more business friendly than the previous one.

Take corporate tax reform as an example. We have no idea what will come of this, but if a tax reform package can be pushed through, it could result in an immediate benefit to the bottom line of many corporations. This would jolt stock prices higher, and may be one of those events that investors cannot afford to miss.

Whether it’s repatriation, a loosening of regulations, revamped trade deals or a big infrastructure bill, there is a lot of “optionality value” baked into the Trump administration.

This doesn’t mean that anything positive will necessarily happen, but it suggests the possibility of near-term catalysts. These types of situations tend to get investors excited – which raises their propensity for taking on risk.

A market that is at all-time highs, combined with the lowest volatility readings in decades, is the perfect situation in which to buy portfolio insurance.

But what makes this an ideal environment to purchase insurance is the fact that the rest of the global marketplace doesn’t think you need it.

Could this be a good time for a contrarian call? I’m not entirely sure, but there is one item in my opinion that screams caution: commodities.

I’ll leave you with the following chart, which shows the CRB commodities index. As you can see, commodity prices have traded in a year-long range and are on the verge of breaking beneath support.

chart 2

A resumption of the downward trend here – which is already evident from the recent lower highs and lower lows, combined with declining 50 and 200-day MAs – would call into question the idea of global reflation.

Instead, it would signal that deflationary forces are gathering steam, and perhaps investors are too complacent for what lies ahead.

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