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Evariste Lefeuvre
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Chief Economist for Natixis North America and Global Head of Cross Asset Research Expertise in international management. Currently oversee a team of 15 strategists based in New York, Paris and London. The team provides high quality global macro research on a wide array of products. Specialized... More
My blog:
The economy, Stupid!
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La Renaissance Americaine
  • SPY: Are New Tops Topish? 0 comments
    Mar 14, 2013 8:31 AM

    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.

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