Earnings Fuel The Bull Market In Stocks, But There Could Be Trouble On The Horizon

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Includes: ADX, AMJ, AMLP, AMZA, BBC, BBH, BBP, BDCL, BDCS, BFOR, BGR, BIF, BIZD, BTO, BUI, CBA, CEM, CEN, CET, CLM, CRF, CTR, CURE, DDM, DES, DGRO, DGRW, DHS, DIA, DIG, DIV, DLN, DOG, DON, DRIP, DSE, DTD, DUG, DVY, DVYL, DXD, EES, EMLP, EMO, EPS, ERX, ERY, EZM, FAS, FAZ, FBT, FCG, FDIS, FDL, FDN, FEI, FEN, FENY, FFTY, FGB, FHLC, FIDU, FIF, FMO, FNCL, FPL, FTEC, FUND, FUTY, FVD, FXG, FXH, GAM, GASL, GASX, GER, GGT, GMZ, GUSH, GUT, HDLV, HDV, HIE, HQH, HQL, HTD, IAT, IBB, IBUY, IDU, IEO, IEZ, IGV, IHE, IHF, IHI, IJH, IJJ, IJK, IJR, IJS, IJT, ITA, ITB, ITOT, IVE, IVV, IVW, IWB, IWC, IWD, IWF, IWM, IWN, IWO, IWP, IWR, IWS, IWV, IYE, IYF, IYG, IYH, IYM, IYT, IYW, IYY, IYZ, JCE, JMF, JTD, KBE, KBWD, KIE, KMF, KRE, KYE, KYN, LABD, LABU, LCEAX, LMLP, MDY, MGC, MGK, MGV, MIDU, MIE, MLPA, MLPG, MLPI, MLPN, MLPX, MTUM, MVV, NDP, NML, NOBL, NTG, OEF, OIH, ONEQ, PBE, PBJ, PBW, PDP, PEO, PEY, PHO, PJP, PKB, PKW, PPA, PPH, PRF, PRFZ, PSCH, PSI, PSQ, PXE, PXI, QCLN, QID, QLD, QQQ, QTEC, QUAL, RETL, RHS, RMT, ROM, RPG, RPV, RSP, RTH, RVT, RWJ, RWK, RWM, RXL, RYH, RYT, SBIO, SCHA, SCHB, SCHD, SCHG, SCHM, SCHV, SCHX, SDOG, SDOW, SDS, SDY, SDYL, SH, SKF, SLY, SMDV, SMH, SMHD, SOR, SOXL, SOXS, SOXX, SPHB, SPHD, SPHQ, SPLV, SPXL, SPXS, SPXU, SPY, SPYD, SPYG, SPYV, SQQQ, SRF, SRTY, SRV, SSO, SYLD, TDIV, TECL, THQ, TNA, TQQQ, TTFS, TTP, TWM, TYG, TZA, UBIO, UDOW, UPRO, URTY, USA, USD, USMV, UTG, UWM, UYG, UYM, VAW, VB, VBK, VBR, VCR, VDC, VDE, VFH, VFINX, VGT, VHT, VIG, VIS, VO, VOE, VOO, VOOG, VOOV, VOT, VOX, VPU, VTI, VTSAX, VTV, VTWO, VUG, VV, VXF, VYM, XAR, XBI, XES, XHB, XHS-OLD, XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY, XME, XOP, XPH, XRT, XSD, XSLV, XTN, YMLP, ZF
by: Andrew Hecht
Summary

Third quarter earnings continue to lift stocks.

The world expects higher highs every day.

The market is optimistic about tax reform in the U.S.

Stocks ignore the geopolitical landscape.

Gravity tells us to hedge and buy the VIX.

Stocks are on fire. The equity markets have become the unofficial poll for the performance of President Trump, and he is going to do everything within his power to keep the bull charging higher. Tax reform and better trade deals, a moderate at the head of the central bank, and policies to spur job growth are the plan. However, “the best-laid plans of men and mice often go awry” according to the celebrated poet Robert Burns.

The President has shunned traditional polls which show him with some of the lowest approval ratings in history. Meanwhile, he may have something because economic growth, expansion, and a rising stock market is a potent formula for success for politicians, and if he can keep the current trend going, he may just achieve success in the mid-term elections in 2018. Moreover, if President Trump begins to rack up legislative victories, reelection in 2020 may become a no-brainer for the forty-fifth President of the United States.

We have never seen a leader so plugged into the daily gratification that the equities market has provided. Daily tweets validate his outright glee over the path of least resistance of stocks. A press conference does not go by where he does not mention the equities market and major indices. Meanwhile, recent earnings reports continue to fuel the bull, but there are issues on the horizon that could derail the rally and cause the leader of the free world to look elsewhere for validation.

Third quarter earnings continue to lift stocks

With a few exceptions, third-quarter earnings reflected economic growth in the United States, and many of the largest companies in the major indices exceeded market expectations and beat earnings estimates, causing stocks to rise to record highs. Additionally, the growing U.S. and global economies have spurred a new optimism that has brought buying to the equities market. Stocks are not the greatest bull market of our lifetime. That distinction could go to Bitcoin these days. However, they are doing quite well, and when it comes to nest eggs in the U.S. and around the world, people are feeling good as the value of their investments is growing with huge gains in the stock market this year.

The world expects higher highs every day

Bull markets are a funny thing; they tend to build on success. In the world of futures, open interest is the total number of open long and short positions in a market. When open interest rises alongside price, it tends to validate a bullish trend. It is the trend to the upside that brings in new market participants all the time looking to ride the bullish wave and increase their net worth.

Stocks have been rallying since February 2016 after a six-week correction shaved over 10% off then S&P 500 index and the other major indices moved significantly lower. However, since the election of President Trump, the flight of stocks has turned hyperbolic with almost a record high in one index or the other on a daily basis. I find myself looking at the final results each day trying to read something into the lack of a new high by the NASDAQ or S&P 500 when the DJIA posts a new record or vice versa. These are the symptoms of bull-mania, and calling a top these days amounts to a fool’s exercise. The trend is your friend until it bends, and this trend has shown no signs of bending, yet.

The market is optimistic about tax reform in the U.S.

The stock market has been rallying for months on the prospects for tax reform and simplification. On Thursday, November 02, the Republicans rolled out their plan to the delight of the stock market. However, there will likely be lots of horse-trading over the coming days before a vote, and the final bill that goes before the House will look a lot different than the original offering. One of the critical issues for the stock market is the repatriation of capital that is held by U.S. companies offshore and lower corporate tax rates. A lower tax rate will bring a lot back, and it will be put to work in the United States providing an injection of fiscal stimulus into the economy. GDP will likely grow in the aftermath of any tax reform legislation that winds up on the President’s desk for his signature. However, there continue to be dark clouds lurking all over the world that could change the path of least resistance for stocks in the blink of an eye.

Stocks ignore the geopolitical landscape

The President is currently in Asia on his longest trip abroad since he took the oath of office. His travels will take him to Japan, South Korea, China, Vietnam, and the Philippines. While he will be discussing trade issues, which, given his “America First” platform, could cause some friction with trade partners in the region and around the world, North Korea will be high up on the agenda. A trade war or tariffs could throw a monkey wrench into the stock market.

North Korea is now a nuclear power. The rhetoric flying back and forth between the President and the leader of North Korea and his henchmen continues to increase the potential for war or violent flare-ups on the Korean Peninsula. Any act of war or further escalation could cause the equity markets in the U.S. and around the world to suffer from a flight to quality and selloff from current highs. At the same time, U.S. relations with Russia continue to be at a post-Cold War low. In the Middle East, the continuing proxy war and tensions between Saudi Arabia and Iran and the blockade of Qatar could suddenly plunge the region into violent conflict.

Meanwhile, last week, the special prosecutor indicted the President’s former campaign manager and another former staffer from the campaign. While the charges have nothing to do with the Russian investigation over the election, the charges were the first shoe to drop, and it is likely they will not be the last. Legal problems at the White House could cause jitters in the stock market in the weeks and months ahead. The bottom line is that with so much bullish froth in the stock market these days, the potential for a correction that comes in the wake of a geopolitical event or crisis remains high.

Gravity tells us to hedge and buy the VIX

President Trump’s nomination of Jerome Powell as the new Fed Chair kept the central bank on the same course of gradual interest rate hikes which has been supportive for the prices of stocks. Fiscal stimulus in the form of tax reform and the potential for an infrastructure rebuilding package in 2018 are all bullish factors for the stock market. The President continues to use equity prices as a sign of validation, but there will come a time when gravity finally causes a correction in the markets. Perhaps he plans to achieve some victories on the legislative front before that correction happens so he can change course and point to traditional polls when stocks are no longer providing an ego boost.

The bull market in stocks is bound to hit a rough patch at some point, and the higher it soars, the uglier the eventual correction to the downside. As of Thursday, November 2, the DJIA has rallied by 19% in 2017, the NASDAQ has posted a 24.7% gain, and the S&P 500 is over 15% higher on the year. No wonder the President is watching the stock market; the gains have been nothing short of spectacular.

When the correction does come, it will blindside many investors and traders as usually happens. One of the best ways to protect portfolios or position for potential trouble on the horizon is via the VIX or volatility index these days. Source: Big Charts

As the chart dating back to 2007 illustrates, the CBOE Volatility Index is trading at the lowest level in a decade at the 9.93 level as of the close of business on Thursday, November 2. The low level of volatility in the stock market means that options are at very cheap price levels. The VIX tends to spike higher during market downdrafts. In 2008, during the global financial crisis, the VIX traded to a high of 90, and over the course of the past 10 years, it moved to over the 40 level on four occasions. The upside potential is currently over four times higher than the current level of the index. Call options or an outright long position in the VIX could serve as a hedge or a speculative position, given the potential for troublesome time and correction in the stock market. The upside potential these days is much greater than the downside risk when it comes to this instrument.

President Trump would like nothing more than to ride the bullish stock market higher throughout his term as the leader of the United States. However, there are more than three years to go in his first term, and the chances are that, as Robert Burns wrote, “The best-laid plans of men and mice often go awry.” The VIX or call options on the VIX is a cheap and effective means of hedging or positioning for the eventual impact of gravity on a stock market. Stocks are not cheap, and there are plenty of dark clouds around the world on the foreign and domestic front that could knock the froth off the bubbling market at any time.

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Disclosure: I/we 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.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.