What Financial Markets Are Telling Us: Breathe Deeply And Focus On Balance When Stretched

High equity valuations are at risk as central bankers have spoken up and voiced a threat of taking away the punch bowl in the form of balance sheet reduction. Still the volatility risk premium points to a higher market over the next few days (though volume may be light since the VRP could easily reverse and catch investors offside), while my technical reading of key stocks in the S&P 500 is neutral. Yesterday's cross-asset action brought several positive factors for US stocks. Oil's chart is signifying global growth. Inflation expectations are stabilizing based on measures of Treasuries and TIPS. But there was also one negative factor across global asset classes. The US yield curve is rising and in the current context that is bearish. Expect the S&P 500 to be range-bound over the next few days.

The surprisingly hawkish Fed minutes turned what had been a mild consolidation into a rout as equities closed right at their lows. But this wasn’t accompanied by more selling in derivatives, as the SKEW index actually declined, while the VIX moved up modestly and the volatility of volatility (VVIX) barely moved up. So the rout was effectively a buyer’s strike, catalyzed by higher interest rates as investors feared the Fed will start to shrink its balance sheet. The impact of such a balance sheet reduction is polemical as it could lead banks back to normal operations in the money markets and thus shift liquidity from the Fed toward the financial sector. This in turn would help financial stocks and leave the market pivoting over whether interest rates rise to the level of inflation expectations: a move up to those levels would be bearish for stocks since valuations are historically high, while a continuation of negative real rates would move the markets to further all-time highs. Key to determining what investors predict is how the VIX acts on a further downmove: it would need to move just modestly higher to the low 20s to signal that rates were moving higher and equities lower.

But even a move lower would be modest as other macroeconomic indicators are positive, such as moderating inflation expectations and the action in commodities. Key to watch is whether gold and copper break below their trading ranges, and whether oil continues its march higher, since that would foster stagflation and fire up the equity bears. As I wrote Monday, I expect the move off the all-time highs set on Monday to be just a consolidation and trading opportunities to arise as the market eventually sets new highs as winter progresses.

My current market positions include a large cash position, and the following holdings: Activision (ATVI), Amgen (AMGN), American Express (AXP), Johnson & Johnson (JNJ), 3M (MMM), Titan Machinery (TITN) and a small net long position in the S&P 500 (the levered inverse ETF SPXU and levered ETF UPRO).