The stock market in 2013 has been challenging for bull and bear alike. The slow march higher has tricked both camps into a lack of conviction. Bulls see the slowing momentum as a sign of weakness, and some who have been bullish since late 2012 have abandoned stocks, like Dennis Gartman. Many a mea culpa has been issued. Bears have salivated at the chance to short what is seen to be a frothy and overbought market. Yet, at every turn, the market found buyers on the dips and continued higher. Only the buy and hold camp has had it right this year.
I see this trend continuing for the year. While corrections will come, I don't think the bulls have anything to worry about. Here's why.
The Volatility Index (VIX) Predicts Compressed Ranges
The pace of the market has slowed, without a doubt. Gone are the days of 2% rallies, but so are the days of 2% drops. The volatility index (VIX) is around 14. An implied volatility reading for the S&P 500 of 14 means the S&P is expected to move 4% higher or lower over the next 30 days. This value is calculated by taking the VIX value of 14 and dividing it by the square root of 12. With the S&P currently trading at 1550, that means the most it would be expected to rise or fall within the next 30 days is 62 points (1612 on the upside and 1488 on the downside). A 4% correction is certainly nothing to be that concerned about since the S&P has advanced 9% year-to-date and 132% since the bull market began in 2009.
Conclusion: What bulls and bears see as a loss of momentum is actually a symptom of a low volatility environment. Therefore, bulls should be celebrating the dips as opportunities to reinvest dividends at lower levels and relax a little since downside is contained.
Inflation Expectations Remain Low
One of my favorite measurements of market sentiment is the spread between the iShares Barclays 20+ Year Treasury Bond ETF (TLT) and iShares Barclays TIP Bond ETF (TIP). I made the observation long ago that stocks performed exceptionally well when the price of TLT was at, above, or near the price of TIP. The exact percentage appears to be around 95%. When TLT is trading at 95% of TIP's price or higher, market performance looking out one year or more has been strong.
The bottom-most indicator in the chart below is TLT divided by TIP. A value of 1 means TLT and TIP are trading at the same price. I put a horizontal line at the 95% mark and then highlighted that region on the chart to show that these values tended to form at lows in the market and were predictive of extended rallies looking out in to the future. TLT is currently trading at 97% of TIP.
I believe this is an accurate measurement of inflation expectations. If investors are bidding up treasuries with maturities of 20 years or more, compared to the flows into TIPs (treasury inflation protected securities), a majority of investors believe inflation will remain low, and the market and economy tend to surprise to the upside.
Conclusion: With inflation expectations running at suppressed levels, the markets and economy will continue to surprise on the upside.
Stay With This Market
Don't be fooled into calling tops in this market, especially with the VIX hovering around 14 and inflation expectations at the low end of a 10-year range. Be patient; reinvest dividends. While "QE Forever" may not be around forever, at least in the near term, it should provide a floor to the markets, as these indicators predict.
For those who want to have a little fun with short-term trading, I recommend following this volatility strategy. Since I wrote the article, it has predicted movement of the VIX quite well and could continue to do so for years. I've posted a few StockTalks with paper trading entries and exits on VIX options, and the strategy has gained 54% (not including commissions) in two weeks.