Evariste Lefeuvre's  Instablog

Seasonality exists for economic research papers as well. Every spring begins with a variety of papers on "sell in May and go away (or come back in November)."

May has traditionally marked a slowdown in equity markets (with the summer off season considered to be the worst investment period). The evidence for this dates back to 1965.

The US economy was suffering from a strong seasonal pattern with Q2 showing some temporary weakness. There is a huge debate on whether this is due to external shocks (Fukushima, weather) or if it characterized a new feature of the US economy. This is important, given omy regular calls on the short run dependence of S&P 500 returns to the economic cycle. Given the weakening of the news flow (regional PMIs, for instance), the timing for a stock exit (or underweighting) may be near. ISM and NFP data will be of utmost importance.

If history repeats itself, then we will check the statistics. The data used below encompass the 1963-2012 period.

The first table below shows that there should be strong incentive to sell in May: not only is the average return much higher in the November/April period, but the tail risk (negative return) is much higher in the May/October period.

The "sell in May" mantra may be regime-dependent. Its impact on portfolio returns depends on whether the Fed tightens or not, whether the market is in a secular bull (bear) market, and whether inflation is above (below) the Fed's target.

The table below shows that the incentive to sell in May is even bigger when the economy is suffering from excessive inflation.

(click to enlarge)

Since the Fed is not tightening, inflation remains tame, and valuation remains attractive for stocks, we have to go beyond statistics. What could be a trigger for a stock selloff?

Of course bad ISM or NFP readings could be short run triggers.

Yet, for stocks to enter a temporary bear market, valuation should be overstretched, which is not the case.

In addition, the chart below shows that the over-performance of stocks against bonds has dwindled over the last three rebalancing period (see http://seekingalpha.com/article/1384351-stocks-and-bonds-the-rebalancing-that-never-was). According to this metric (relative performance of stocks and bonds over the short run), there is no strong call for a sharp correction in stocks

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.

The EU and the IMF have acknowledged that Cyprus should apply capital controls, temporarily violating one pillar of the four freedoms: liberty of goods, services, people and capital. There is an ongoing debate about whether or not it breaches Article 63(1) of the Treaty on the Functioning of the European Union. I focus on the economic impact of such a move.

There are several forms of capital controls: quantitative, administrative, taxes. Their purpose is often country-specific and linked to one or several of those issues: appreciation of the currency, hot money (alters the composition of capital flows), large inflows (reduce the size of capital flows), loss of monetary authority, and risk of sudden stops in foreign inflows. For that reason, there is no unified theoretical framework and huge heterogeneities in the conclusions of empirical studies.

Controls can focus on capital inflows (a method of hindering inflows of hot money in emerging countries) or outflows, short run or long-term flows, take the form of price-tax control or quantitative control.

The official/supranational view on capital control has changed over the last decade. Since the early 2000s, capital controls have sometimes been seen as economic policy "options": they may contribute to financial stability, but generally only when "any other policy choices have been exhausted" (IMF).

Among other things, control of outflows was implemented in Iceland in 2008 to avoid a worsening of the already dire financial meltdown. Their implementation in Cyprus also reflects the exhaustion of other options.

There are numerous critiques of capital controls:

1. Longevity: exiting capital controls are usually much more complicated than expected. In Iceland they are still in place after 5 years, and they are looking to delay lifting them for 2-3 years, or when financial conditions are substantially improved, though the current law says they will be lifted in 2013;

2. Negative impact on investment: capital controls impede foreign direct investments and are an incentive for households to keep their wealth in liquid asset (ready to exit the day controls are lifted);

3. Interest rates are distorted by a risk premium which translates into an inefficient allocation of capital;

4. Another pillar of the four freedoms is at stake: the liberty of people's movement, as travel is restricted.

Cyprus shares several of Iceland's difficulties, including a huge amount of foreign depositors. In all cases, huge withdrawals by foreign investors would weaken an already broken banking system. But while the exit of foreign depositors threatened the exchange rate of the Krona, it could cause recession and deflation in Cyprus. Another difference with Iceland was that during the 2008 crisis, all Icelandic domestic deposits were guaranteed by the government, which helped to avoid a bank run.

There is a well know monetary identity, called Fisher's equation: MV=PY

Monetary base times velocity of money equals price level times GDP. If M falls as a result of capital outflow (assuming V will remain unchanged), the country is facing the double threat of deflation and recession as the exchange rate is fixed.

Following the IMF's advice, Iceland decided to avoid a disorderly collapse of the external value of its currency. In the case of Cyprus, the key is to avoid draining an already illiquid (and insolvent) banking system and to avoid a recession/deflation.

What could be done?

It has been said that some other options could have been implemented, such as a tax on capital outflows, but this measure remains a soft version of capital controls.

As the Troika expects a sharp reduction in the size of Cyprus' banking system, and as foreign deposits made up more than 15% of its liability, those deposits that will not be swapped into equity will have to eventually exit.

One solution would be to resort to the Exceptional Liquidity Assistance (ELA): a large amount of the exit of foreign depositors from Irish banks between 2008 and 2011 was carried out by borrowing at the central bank. This would lead to a change of the liabilities of the banking system that the ECB (through TARGET2) may not be ready to accept.

What should be done?

To quote Schauble, deposit guarantees are "as good as a state solvency," so the crisis calls for a deeper banking union and in particular its third pillar: the insurance of deposit. If Cyprus' citizen never doubted the guarantee on their deposits, the risk of capital outflows would have been much more manageable.

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.

As the SP 500 breached a historical high, the VIX fell to a pre-crisis low. For many investors this means that the market is "too complacent" or "ahead of itself." Is this the case?

Stocks reach new price highs but not valuation highs

The chart below shows the last three tops of the SP 500 (purple lines). It also shows where the current price level stands against the implied level of Price-Earnings Ratio.

i. Episode A is Alan Greenspan's "irrational exuberance" in the mid-1990s. Valuations were much higher than what could have been considered a maximum valuation threshold (PE around 16x).

(click to enlarge)

ii. Episode B refers to the pre-Great Recession period. Valuations were high, but there was no clear evidence of an equity bubble.

iii. Episode C is the present-day scenario. As can be seen in the chart, the current level of the SP 500 is well below the level that would be implied by a PE of 16. Stocks are getting more expensive, but there is no clear-cut signal that they are getting too expensive.

On a short term basis, there might be some relative richness against many other asset classes, but current valuation level suggests that there is still some room for stocks to increase before year-end.

Of course, there might be some short run corrections, but they will not be driven by overstretched valuations.

VIX is not too complacent and less relevant than ever

VIX closed under 12 for the first time since April 2007. As can be seen below, VIX can remain in that area for many years before the stock market crashes.

More importantly, the absolute level of the VIX matters much less than the shape of the VIX curve. The charts below show two episodes of "complacency:"

i. in 2007, the slope of the VIX Futures curve turned negative. This backwardation (futures cheaper than the spot) was a good opportunity to buy VIX future as the roll was positive.

ii. today, the curve remains in contango: buying protection is costly as the roll is negative (next month's future are more expensive). Any investor willing to protect himself against a rise of the VIX is exposed to the possibility that it is not strong enough to offset the cost of the roll.

(click to enlarge)

It might be a good time to reduce the exposure to stocks at this stage. Some negative shock might lead to a short run correction. Yet, valuation and "complacency" reflected by the VIX level should not be considered serious enough scapegoats to exit from the stock market.

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.