Markets are calm right before the storm, and according to the VIX, the S&P 500 is very calm.
As the chart above depicts, we've seen two full bull cycles and are currently working on the third. The CBOE Volatility Index (VIX) (NYSEARCA: VXX), depicted in blue, represents the implied volatility of the S&P 500. As you can see, the difference (grey) between the VIX and the S&P 500 (orange) has magnified significantly over the recent years. Given all the recent political and economic turmoil we've faced (and will continue to face), it's odd to see implied volatility near its all-time lows. That's why I think a reversal is in our near future.
This is Not the 1980s
This year has been filled to the brim with both political and economic uncertainty, and yet just recently a last attempt "Trump rally" has been trying to gain momentum. I don't believe the Trump rally has any substance. The market has rallied because of the general view that Trump will lower taxes and increase spending. Some believe we may see similar economic conditions to the 1980s - a time when the market rallied significantly.
Let's go back in time, then, shall we?
During the 1980s, the markets were facing a great deal of uncertainty. The banks had gotten into trouble with their rampant emerging markets lending, leading to unprecedented actions being taken by the central banks to provide hopes of stabilization. The problem with emerging markets, however, was not going away just because lenders were given greater flexibility to cope with their piling issues (i.e. issuing new debt to pay off old).
Something had to give to jump-start the economy, and that something was looser monetary policy. Look at the charts below:
The 10-year rate:
With Reagan's massive defense spending, his trickle-down theory of cutting taxes to optimize revenues to bring the budget deficit into break-even territory turned out to be incorrect.
In turn, the increase in the budget deficit allowed the dollar to rise to extreme levels as shown below:
What worries me the most about the current state of the market is that monetary policy will not help going forward. The bull market of the 1980s was not caused by the fiscal measures undertaken by the Reagan administration; it was the lowering of the interest rates that caused the bull market to begin in 1982.
- A rising dollar equates to lower revenues and profits for companies that have extensive international exposure;
- Interest rates will go up, therefore suppressing the present value of cash flows, making the more leveraged companies increasingly riskier, and hurting consumption;
- Geopolitical risk (the upcoming Italian referendum, for example);
- The scary looking VIX chart at the beginning of this article.
Now is the time for caution and to begin building a cash position to take advantage of any potential opportunities later. For those who dabble in options, now is also the time to accumulate a short position on the SPY via put options. With implied volatility being as low as it is right now, options look quite compelling.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY over 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.