A summary of quality long-term indicators of the health of the bull market for the S&P 500 (SPY).
A look at volatility, inflation expectations, the TED Spread and sentiment.
Actionable market advice for the long-term investor.
As another crisis brews in the financial markets and the global stage, it is worth reconsidering the view I expressed about one year ago, which was unabashedly bullish. The S&P (NYSEARCA:SPY) was trading at 1563 when that article was written. The market has advanced about 18% since then and went on to record the best year of the bull market yet.
The indicators that I used to make those call turned out to be correct, so it would be useful to examine where the market health stands today using the same set of reliable long-term indicators. I do not pay attention to the media, global conflicts or economic data points. Rather, the indicators speak to the underlying health of the market, which is the best predictor of the future. The headlines of the day don't tell you much except what has already been discounted.
The four key indicators I will examine in this article are:
- Inflation expectations
- The TED Spread
In order to turn bearish on the markets, something drastic has to change in the range of the volatility index (VIX). My bullishness last year was partly contingent on the 10 day average of the VIX remaining in the "secular bull" range of 10-20. (A full discussion is available here.)
On that front, nothing has changed. The VIX is still behaving exactly as one would expect in a secular bull market. An elevated VIX would be a warning sign. The 10 day average would need to rise to 20 or higher for more than a few months before giving a bearish signal. Considering the apparent "risks" associated with the economy and Russia, the VIX is simply not confirming that these are anything to worry about yet. The low volatility cycles of the past tended to last at least a few more years. We are likely in the middle innings of a low volatility cycle.
One of my favorite measurements of market sentiment is the spread between the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT) and iShares Barclays TIP Bond ETF (NYSEARCA: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 96% of TIP, almost exactly where it was in March of 2013.
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.
The TED Spread
The TED Spread is a measurement of market liquidity and counter-party risk. It is the spread between 3 month LIBOR and "risk-free" 3 month T-bills. A rising TED Spread indicates withdrawn liquidity and increased risk to interbank lending. Therefore, a rising TED Spread is bearish and a low TED Spread tends to be bullish, since there is no systemic financial risk. The current TED Spread is issuing no kind of warning about the markets. In fact, it is one of the lowest readings of the bull market.
My favorite measurements of sentiment are the ISEE Put/Call Ratios. These are the most unfiltered measurements of sentiment because they show exactly what retail traders are doing in their accounts rather than what they say on an investment survey, which is subject to all kinds of biases and flaws in methodology.
ISEE Equity Put/Call Ratio
The equity put/call ratio shows the ratio of calls to puts for equity options at about the middle of its long term range. A recent spike has led to a mild correction in the markets, and that correction could go a little further, but the market sentiment is still nowhere near the peaks seen in 2007 and 2011. The yellow line is the 50 day average.
ISEE Indices & ETF Put/Call Ratio
The indices and ETF put/call ratio shows the ratio of calls to puts for index and ETF options at about the middle of its long term range. Were this to rise much more, I would get a little concerned about a deeper correction, but not necessarily one that would end the bull market. The yellow line is the 50 day average.
Not a single one of these indicators has turned bearish yet. All of the indicators are in agreement.
- Any correction is still a buying opportunity
- A major bull market top has not been seen yet
While nothing presented here guarantees that 2014 will be anything like 2013, or that there won't be a sizeable correction, any predictions about the demise of the bull market this year should be dismissed. The long-term outlook of the market is still decidedly bullish.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.