Evariste Lefeuvre's  Instablog

Stocks Hit New High: What's Next ?

The S&P500 reached an all-time high.

I checked to see if 1-month returns of US stocks against several other assets would offer any information. I used a simple statistical tool: the 26-day rolling z-score.

It assesses to what extent the current return differential (1-month return of a given asset vs. 1-month return of the SP500) remains within the +/-2 sigma area.

Barring any black swans, a breach of the upper or lower bound is generally followed by a mean reversion, as can be seen in the chart below: whenever S&P 500 (SPY) returns overshoot Brent returns, the spread adjusts back to its medium run average.

the question now is: Has the S&P 500 outperform too much? Is it poised to fall or not?

The answer to the first question is: yes.

the answer to the second question is: not necessarily.

I did the same calculation on the FX spectrum (EUR/USD and EUR/JPY) as well as with copper and the High yield total return index (HYG). (below an example with EUR/USD vs. S&P 500).

All my charts (except one with junk bonds) come to the same conclusion: there is a clear cut overshooting of stocks.

But with such an analysis, the glass is neither half full nor half empty. Mean reversion does not necessarily mean that stock prices have to fall. They just have to underperform other risky assets.

In many instances when the spread fell below the 2-sigma lower bound, the stocks registered a positive ex-post 1-month return. The chart below shows the one-month forward return of the S&P 500 (dotted line). In at least 3 episodes, the mean reversion process came along with higher stock prices (positive return) not falling stock indexes.

(click to enlarge)

Though it is true that breaching new highs does not necessarily imply a short term drop in stock prices, the recent outperformance of stocks is not synonymous with negative returns, just under-performance.

Stock may underperform, but not necessary fall.

For stocks to continue to grow, two tailwinds are required:

i. a positive news flow (recent ISM and ADP data suggest that it is still improving)

ii. attractive valuations. For now, forward Price Earning Ratios are still in their medium run range. In addition, the chart below shows that Earning Per Share growth forecast for the US has been revised more sharply than in the euro-zone and are consistent with a 2% GDP growth rate in 2013.

For that reason I believe that stocks may underperform other asset classes in the near future, but it might not be on the way down.

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.

For many traders, the USD/MXN is considered the best hedge against SP 500 adverse moves. Said differently, the pair continues to react strongly to risk-on/risk-off episodes. On the contrary, the Aussie dollar is more sensitive to domestic factors as the correlation with the SP500 has weakened significantly

To dig deeper into this disconnect, I focused on the implied volatilities of both pairs. The chart below shows that the ratio of USD/MXN to AUD/MXN 3-month implied volatility is tracking the Gold-to-Oil ratio quite well. A higher GOR means higher risk aversion (gold outperforms oil when risk aversion rises), which comes along with an increase in the volatility ratio.

I also compared this implied-FX-volatility ratio to the ratio of VIX (implied stock market volatility) and the implied volatility of options on the first nearby T-Note future (see chart below).

Despite some temporary divergences, the link is quite robust: the FX ratio is highly sensitive to the relative implied volatilities of stocks vs. bonds. For that reason I say that MXN is Stocks and AUD is Bonds.

For medium run investors afraid of the Fed's exit from QE, it might be a useful tool: the chart below shows a wide disconnect between the price and the implied volatility of the first nearby T-Note future. Normalization of the monetary policy would come along with a (slow) convergence of bond price and volatility, pressuring the VIX/bond volatility ratio upward.

In the short run, the likelihood of a lower AUD/MXN and higher stock prices remains, if the correlation observed since 2012 does not break down (see in particular the negative correlation between the SP 500 and the AUD/MNN circled in the second chart below).

(click to enlarge)

Based on the recent cross-asset relationships, the continuity of the equity rally should translate into a lower AUD/MXN.

The recent rebound of the AUD/MXN on a major support may temporarily halt the relationship, unless a slightly more hawkish RBA and a better than expected GDP utterly changes the ongoing negative reading of Australia's data. Something that remains dubious.

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 disconnect between the EUR/USD and the SP 500 has widened as PMI on both sides of the Atlantic diverged significantly. Last time this happened was in July 2012, days before Mario Draghi saved the single currency with a single sentence: "whatever it takes" to save the Euro.

The question is: should we take this as a signal of lower US stock indexes ahead?

There is a striking point that is worth mentioning. As can be seen on the chart below, the VIX curve (6th or 3rd contract vs. first nearby contract) is recoupling with the EUR/USD risk reversal (the difference between the volatility of the call price and the put price with the same moneyness level).

(click to enlarge)

As the decline of the EUR/USD risk reversal suggests a plummeting confidence in the pair, an inversion of the VIX curve (actually, a flattening of the futures curve, which suggests that the demand protection in the short run is rising) implies rising risk aversion.

The VIX curve does not always provide a strong signal on the future path of stock prices (ex. last December). But the Gold/Oil ratio is also sending a bearish signal. I would lean towards believing that the three bearish signals should be taken seriously.

Hence, a "sequester" trigger could bring stocks lower, but the chart below (stock prices return are highly correlated to the economic cycle - here the US ISM Manufacturing) suggests that the cyclical momentum is strong enough for stock prices to adjust but not collapse.

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.