When confronted with inexplicable market action, the answer usually is not “Look, everybody else is crazy”. The market is comprised of millions of very rational investors (some vastly more informed than others) and as a result, if the market action does not conform to your present theory, a new theory must be formulated. There are always legitimate reasons behind the major market moves and as market observers, analysts and investors we need to find out what these reasons are. Unfortunately, for most investors, the reasoning becomes clear in retrospect usually months and years later. Here, we will try to keep pace with this incredibly fast paced market.
Since the lows of August/September, there have been a few notable developments:
1. Prospects of Negative Interest Rate Policy regime are heating up
a. Mixed/weak economic statistics have silenced the rate hike discussion.
b. A number of FED governors have reiterated the stance that rates should not go up and Bill Dudley, the most prominent one, even discussed the concept of Negative Interest Rate Policy (NIRP) with Steve Liesman.
c. On October 14th, John Williams, Janet Yellen’s right hand at the San Francisco Fed publishes a paper advocating Negative Interest Rate Policy (NIRP). In the paper, they state that -2% is the present natural rate of interest in our stagnant economy and as result zero interest rates are far too high to be stimulative for growth.
d. On October 22nd, Mario Draghi of the ECB, discussed the usage of a combination of QE and NIRP in his bid to revive inflation and economic growth in the ECB. While that immediately strengthened the dollar and put earnings growth for SP 500 companies at even more risk for 2016, what is more important is the precedent. In other words, if the ECB recommends a combination of NIRP & QE as a policy tool, the FED will certainly consider it.
2. Prospects of Tax Reform that favors corporations are heating up
a. Donald Trump is looking more and more like the nominee of the Republican Party. Donald Trump openly advocates tax reform that will
i. Lower corporate tax rates to 25% from 39%
ii. Remove the global tax regime for American corporations and replace it with territorial
b. Paul Ryan looks like a shoo-in to be the next House Speaker. Paul Ryan’s tax policy is very much in line with Donald Trump’s.
There was also the China interest rate cut. I’ll leave the China and the Tax Reform discussions for future newsletters. Today, I’ll discuss the most important of these macro drivers– the Negative Interest Rate Policy.
Negative Interest Rate Policy
One of the key valuations criteria for stocks is the Dividend Yield. In asset management theory and practice, when SPX dividend yield is higher than 10-Year Treasury Yield, you should buy stocks (the stock index SPX) – not only do you get higher yield, but you can also get capital & earnings appreciation. The reverse is also true. As a result, the Dividend Yield in the SPX looks over a long period of time to equal the 10-Year Treasury Yield. In fact at present they are virtually equal with the S&P 500 Dividend Yield at 2.03% and the 10-Year Treasury Yield at 2.08%
If the FED undertakes a negative interest rate regime in the near future (next 6 months to a year), this will have the following effects on the market:
1. The dollar will stop its massive move up as the 10 Year German Bund – Treasury spread will go down from 1.5% to a more reasonable level and the massive government and institutional manager money flows will stop seeking US treasuries nearly as much.
2. If the dollar stabilizes, oil and metal prices will stabilize, the prospects of massive defaults in the energy and materials sectors go away (currently the only weak point in the market) and the prospects of continual negative earnings growth go away as well.
3. If the dollar stabilizes, SPX corporate earnings will stop cratering on the way down as foreign earnings will not have to discounted so much
4. Stock buyback bonanza continues unabated and is actually amplified
But the most important effect is this:
5. The 10-Year Treasury Yield will do down below 2%
I have put together the following table with possible implementations of NIRP and associated Treasury Yield and Dividend Yield levels. The table assumes that annual SPX GAAP earnings will stay stable at the latest reported value of $93 per share and that the dividend will also stay stable at the latest reported value of $42.12 per share
The take away from this table is this: the FED still has an enormous power to drive the SPX higher by implementing a NIRP regime. A mere -0.10% on the FED rate can move SPX valuations up to the 24 P/E level. -0.25% FED rate can move valuations to the 26 P/E level and the SPX all the way up to 2400 level.
For a reference point, the current 2-Year German Bund yields -0.32%, so a -0.25% FED rate is NOT out of the question.
I am borrowing this table from Charlie Bilello, just to illustrate that NIRP is not only a possibility but a present day reality in most of the biggest European economies
So what’s going on here is the market is trying to front run as fast as it can FED policy. If those “in the know” know that the FED is seriously considering NIRP, by the time the announcement is made in March or September of 2016, all the gains in the SPX will have been made. If you look for a driver behind the spectacular rise in the market this week, this is probably it.
Fastest VIX drop from 40 to 14 In History
The SPX sliced through a number of important technical levels over the past couple of weeks – the 50MA, 100MA, 200MA as if they don’t matter. The fact is those levels are extremely important and there are a lot of automated investment algorithms that invest based on those levels. Now, however, from resistance these levels have turned into support. With that in mind, with each breakout, volatility plunged down further and further.
In fact, this is the fastest drop from a closing value of above 40 in the VIX down to 14. It took only 42 trading days. In previous VIX spikes, it took at least 216 trading days (Oct 2011 to Aug 2012) – almost a full year (a year has 252 trading days) for the VIX to do that. On most occasions, this is a multi-year decline.
This was the reason why in prior emails I called for a secondary VIX spike at least to the 30 level. If 50MA and 200MA presented meaningful resistance that would’ve happened and that is what has always happened in the past. But the markets are more informed now, more automated, faster and as result more schizophrenic and fast moving. And more surprising as well – always moving ahead of historical precedent. If people loaded up with shorts at the 50MA and 200MA expecting resistance, the market makers would look to hurt the most amount of people and they would move the futures up forcing the shorts to cover once at the 50MA level and then at the 200MA level. So add positioning to the fundamental NIRP story and you have the massive W recovery we’re observing right now.
The volatility situation continues to improve dramatically without a pause since we identified the turn in the September 22nd newsletter:
a. Volatility Curve is now in a normal Rally Formation with the VX8 below the Historical Average with a steep front-end.
b. Short Term Structure measures (VDelta) is now in a 0-2 band meaning that VXST is below VIX and that doesn’t portend a big VIX jump soon
c. Medium Term Structure measures (Contango & VCO) are now itching to turn green. The VCO of 25 and Contango of 5% are in sight. Roll Yield is also at 14.6% with Contango Roll at 19%. High Contango Roll, high VCO and Contango the best predictors of XIV success and XIV looks poised to launch another winning streak.
d. Long Term Structure measures (VRatio & VTRO) are solidly in the green with no reversal in sight pointing to solid volatility situation going forward over the next 3 months.
e. Volatility of Volatility (VVIX) has now spent weeks below 100 suggesting that the mania of August is somewhat over.
f. Volatility Momentum (VForce) is now very negative at -34%. This is a positive development for the market and this has happened only 3 times before – 1998-11-23, 1991-03-14 and 1991-03-15. In prior instances, the market ended up moving higher and the VIX 50MA moved down
g. Volatility Risk Premium (VRP) is slightly positive but expected volatility is dropping faster than historical meaning the market feels much better about its prospects going forward
The entirety of the Volatility Curve and VIX Term Structure are now in a state that portends positive performance for the Short Volatility ETF (XIV) going forward. The 50MA and 200MA now act as support instead of resistance. Unless we break below the 2060 level for good, we can expect volatility to continue to be suppressed.
Over the next week, there is one remaining risk, however. The House Speaker election and the Debt Ceiling resolution. Historically, a couple of days before the event, volatility has spiked, a successful resolution has been implemented and then volatility resumed its decay downward. Buying on those pre-event VIX spikes has often resulted in daily gains for the XIV of about 8-10% which have later extended to 60-70% gains over the next 2-3 months. For example, the Debt Ceiling and Fiscal Cliff of 2012 resulted in a 60% run in XIV from Nov 9th 2012 to Mar 19th 2012. After the Debt Ceiling of 2011, we had a 75% run from Nov 11th 2011 to May 14th 2012.
My expectation here is that over the next week, we may have a brief spike in the VIX with a rather neutral performance for both XIV and VXX. Once the Debt Ceiling gets resolved, I expect the market to slowly grind higher or back and fill into the New Year as it reprices to a new P/E multiple (it has already breached the 22 PE level at the close this Friday). At this point, the only resistance area on the horizon is the 2131 all-time high from May, but given the multiple expansion, I am not so sure it will present meaningful resistance.
On news of the resolution, I expect the VIX to drop below 15 and stay in a 12-15 range for a few months. In such a market neutral or market positive scenario, the XIV would benefit greatly as Contango stays above 5% and Contango Roll stays above 15%. The XIV will outperform the SPY dramatically and looks poised for another 50-60% run into the New Year and beyond.
Devil’s Advocate Scenario
Alternatively, you have to consider that if the long trade gets overcrowded, the market may throw another 3-5% dip for a couple of weeks in November or December to clear out the weak hands. However, now I view that as an XIV buying opportunity. The probabilities and term structure now favor XIV far more than VXX. The VXX will only gain over the long term if we have a major VIX spike to above 30 at which point the Volatility Curve inverts. That can only happen if the market drops and drops fast like in August. We have to top out at a lower low in the 2080-2120 area, then drop down fast below the support areas listed below (200MA = SPX 2060 or mid-year support of 2040) for an extended period of time.
The market’s natural tendency is to grind higher with some volatility episodes like the past few months thrown in. If it wasn’t for Central Bank intervention, we definitely had the beginnings of a bear market on our hands, but Central Banks are intervening and we can’t ignore that. At this point the SmartXIV and UltraXIV strategies are on the cusp of issuing a “BUY” signal for XIV. Sometime after next week, I expect the signals to trigger once the Debt Ceiling situation gets resolved.