With the market in a classic oversold condition, equities rallied heavily on Friday, seemingly in response to the (good?) Chinese GDP report and retail sales figures, along with JPMorgan (JPM) and Wells Fargo (WFC) earnings.
At the risk of sounding perma-bearish, I'd like to take the other side of today's rally and explain that absolutely no fundamentals have changed, and equities are once again showing serious complacency.
Short-Term Volatility Indicating Little Fear
For all of the financial headlines we read exclaiming that investors are overwhelmingly bearish, nothing I can see in the marketplace indicates this historically abnormal pessimism.
The Spot VIX (VXX), is trading at 16.74, well below its historical average of about 20. Now, it is in fact true that the VIX is not a "fear" indicator, but rather a reflection of expected volatility. That being said, with the VIX below its historical average, that implies that the market expects short-term gyrations, usually driven by important headlines, to be at a minimum. And given the nature of equity price action over the past couple of years, if there's no headline news, the market is on a smooth path upward. There are no smooth paths in a downtrend.
Additionally, the VIX futures curve is implying a significant uptick in volatility over the next few months. The October VIX contract trades at 22.75, a 36% premium.
Secondly, let's think about the dynamics of the price action. Last Tuesday, I watched in the early morning futures trading hours as the Dow soared as much as 85 points in response to the Eurogroup meeting, which spit out nothing of importance. The fundamentals are screaming to sell, but traders and investors alike are hooked on trying to find something to rally on.
No Risks Have Been Removed
Here's what the market has been worried about recently:
Spanish and Italian debt costs
A poor start to the 2Q earnings season
Sub 8% growth in China, slowing Brazil and India, a deepening recession in Europe, and sub 2% growth in the U.S.
A lack of stimulative firepower from the Fed or the ECB
In an article soon to be published, I note a recent story from ZeroHedge explaining that JPMorgan just lost its "internal hedge fund," and up to 30% in annual net income. With JPMorgan actually breaking out the CIO operations in its earnings, the logical conclusion should have been the following: Now that the CIO actually has to mitigate the banks' risks, it should be a perennial loss generator, as opposed to a multi-billion dollar profit center. From a total market perspective, investors should be more spooked than ever about the hidden risks in our fragile and shady financial system.
As for debt costs, Spain's 10 year rose on Friday to 6.66%, while Italy's 10 year bond rose to 6.05% in response to its credit downgrade courtesy of Moody's. These are unsustainable crisis levels, and unless the EU can get the ESM ratified and running very soon, the lack of physical bond purchases is going to be a shock to the peripheral sovereign markets.
In terms of earnings, industrials like Cummins (CMI) and Alcoa (AA) have cited weaker than expected economies in China and the rest of the BRICs, while chip-makers like Advanced Micro Devices (AMD) massively cut guidance due to the ongoing European implosion. It's early, but the early reports have corroborated with predictions of a weakening in revenues and margins. I fully expect companies like Intel (INTC) to disclose serious weakness in its huge Asian business, and Apple (AAPL) estimates (calling for 33% EPS growth) don't seem to take into account weak consumer confidence reports.
The market was unable to rally last week in response to $50 billion in QE from the Bank of England, a rate cut from the PBoC, and a rate cut from the ECB. Markets are requiring ever more incremental liquidity injections to see positive effects. With the Fed unwilling to ease (at least until energy and equity prices fall further), there's no real catalysts to keep this rally going, unless earnings start surprising in a big way.
With short-term volatility at complacent levels, easing measures having little effect, earnings off to a poor start, and peripheral yields still at distressed levels, equities are once again failing to price in risk.
Trading Strategy: I expect this coming week to show sustained selling. With Citigroup (C), Intel, Coca-Cola (KO), and industrials like Johnson Controls (JCI) and Nucor (NUE) reporting, the earnings picture should round into shape.
I covered my S&P short futures position early Friday morning, but still own some longer dated put options on the SPY, and am looking for another entry point from which to short the E-minis.