Myth Busters Part III
Is it logical for equity investors to be concerned about any of the following?
- Weakness in economically-sensitive small caps.
- A near-record low VIX "Fear Index".
- Recent demand for defensive bonds.
The answer is "yes". The three bullet points above are relevant to the stock market's risk-reward profile. However, the question is how relevant? We recently showed examples that aligned with the theory that "nothing says small caps cannot begin to find their footing again". After making an intraday low on May 15, small caps (NYSEARCA:IWM) rose 6.0%, telling us to keep an open mind about the possibility of a sustained rally in higher-risk/higher-reward stocks.
Building The Flexibility Case
In a detailed May 29 article, we showed it is possible for stocks to post impressive gains during a period when the VIX rises significantly from low levels. The purpose of the small cap and VIX articles is not to build a bullish case, but rather to emphasize the importance of respecting both the bullish and bearish cases for stocks; doing so allows us to maintain the always-important flexibility needed to remain aligned with the market's current profile.
Bonds: How Concerned Should Stock Investors Be?
It has been easy to find "bonds are saying be careful with stocks" articles in recent weeks. It is prudent to be concerned when demand for defensive-oriented bonds is strong. However, it is also prudent to ask:
Can stocks and bonds rise in unison for long periods of time?
The chart below shows one of the periods in the table: June 28, 2006 to December 1, 2006.
But, The Economy Is Much Different Today, Right?
Yes, the economy in 2014 is quite a bit different than all the historical periods referenced above. The same argument can be made for any period we cite as potentially bearish evidence for stocks when bonds were strong. The point of the article is not to compare economic similarities, but rather to answer the simple question - Is it possible for stocks and bonds to rise in unison for extended periods of time? The answer is yes.
A Bar Is Worth A Thousand Words
Since a table of numbers does not provide a visual reference point, we have provided the bar graphs below showing the percentage changes of SPY, IEF, and TLT for each period in the table.
How do we use all this? Small caps, the VIX, and bonds are all helpful in terms of managing stock market risk. However, there are more effective ways to monitor the big picture for equities. For example, stocks cannot morph into a corrective state until we see visible signs of a breakdown on the weekly chart below. The top portion of the image below shows what the early stages of a correction looks like; the bottom portion shows the market as of 2:24 p.m. EDT Friday.
If the 2014 chart above maintains its present look, it does not matter what small caps, the VIX, or bonds are doing; it is not possible for too many bad things to happen, especially a multi-month correction or new bear market. Therefore, until a breakdown in the major averages occurs, worrying about bonds may do nothing but sap productive energy from well-intentioned investors.
We use our market model to monitor the market's risk-reward profile and make prudent allocation adjustments. There is no such thing as a perfect market indicator. Therefore, our market model uses numerous inputs. Since weekends are a good time to review your approach to the markets, this October 2013 article covers the basics of "monitoring and adjusting" rather than "forecasting and hoping"
Disclosure: I am long SPY, TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.