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Is Market Correction Over or Just Beginning?


Independent of Washington, volatility may continue to rise as earnings season hits.

Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever.
--Nassim Nicholas Taleb

US stocks have been more volatile lately as Washington bickering causes nervousness about what will happen next in the markets. I see a lot of people on Twitter and in the media arguing that the moment a deal is made, markets will resume their uptrend. Perhaps this is true, especially given that emerging market strength is unquestionably gathering steam, which could hold global beta sentiment up. However, it is worth considering the possibility that US averages could still be under pressure, due more to earnings and renewed uncertainty over tapering.

Inflation expectations have notably diverged from equity prices in the US, which I have hammered all year as a big theme many seem to be underappreciating. Growth estimates for next year have been cut by both the Fed and the IMF. On a rolling 52-week basis, small-caps (NYSEARCA:IWM) are overbought. Earnings growth does not appear to be strong enough to justify the extent of P/E expansion this year, and leverage in equities is at an elevated level. From a contrarian standpoint, there are more than enough reasons to be negative on US stocks.

What about from a volatility perspective? While the VIX (INDEXCBOE:VIX) by itself is more reactive than predictive, the shape of the term structure of bets on future volatility can be indicative of a coming change in sentiment. Take a look below at the price ratio of the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) relative to the iPath S&P 500 VIX Mid-Term Futures ETN (NYSEARCA:VXZ). As a reminder, a rising price ratio means the numerator/VXX is outperforming (up more/down less) the denominator/VXZ.

When shorter-term VIX futures are outperforming longer-term ones, it indicates that money is betting that near-term volatility will increase relative to volatility in the future. When the ratio outperforms and that strength sticks, it means that money is aggressively preparing for a decline in equity prices. Note that the ratio appears to be in somewhat of a bottoming process, and the strength still appears to be early. The implication? If the trend holds past Washington negotiations, the pain may not be over yet for US stocks. My firm's ATAC (Accelerated Time and Capital) models used for managing our mutual fund and separate accounts, which are currently in emerging markets, are nearing a defensive rotation regardless.

October getting fun yet?

Twitter: @pensionpartners
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No positions in stocks mentioned.

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