The Drop
When an object falls into a pond, the initial big splash quickly disappears, followed by several secondary disturbances before the water calms down. The unravelling of the “short volatility trade” in the first week of February, certainly made a big splash across assets (equities and bonds), lifting the VIX to levels not seen since the correction of 2015. The initial disturbance looks to have dissipated — the SPX recovering 62% of the correction, and sentiment returning to the 50% and 20% levels, bull and bear, respectively, but secondary splashes have yet to develop.

We expected this to occur based on the similarity between the correction in 2000 (C4) and what we are experiencing today. If trading continues to rhyme with the year 2000, then we can expect a secondary splash to come as soon as next week. (charts below)

Despite all this splashing around, we do not see this as the start of the next bear market. We are in the later stages of the bull market, however, and we are building up to a crescendo of positive sentiment and certitude (which will signal the approaching end), but we are not about to enter a bear market just yet. This is simply a much-needed correction. Why do we think this way?

Let’s count the ways:
Earnings

  • Q4 earnings for the S&P 500 are up +14.5% y/y, revenues are +9% higher, 78% of companies are beating EPS estimates, and 75% are beating revenue estimates.
  • According to FactSet, earnings is expected to increase by double digits in every quarter of 2018, and to reach +17.9% y/y.
  • The correction has brought the PE of the S&P 500 down to 19.17 (based on trailing 12m earnings), and the forward PE is 17.25 (based on forward 12m estimates).
  • Small business sentiment is as high as it has been in 15-years (chart below)

Inflation and Interest rates

  • The CPI was up 2.1% y/y in January, with the core up 1.8%.These are not high inflation rates when compared to the past, or to the Fed’s target of 2.0% inflation.
  • PCE (personal consumption expenditure), the Fed’s preferred inflation gauge, is only up 1.7% y/y, and the core PCE is only at 1.5%.
  • These relatively low inflation metrics, especially the PCE, means that the Fed is unlikely to raise rates faster than they have already telegraphed to the market (3 hikes this year).
  • Bond rates have been rising, but they are coming off extraordinarily low levels.The expanding business cycle will be able to absorb these higher rates — at least for the time being.

Political Effects

  • Although we view the Tax legislation and fiscal plan as a mis-timed action in the long-term, in the short-term, the lower tax rate on businesses and the infrastructure spending that is planned will be stimulating to the business cycle and deliver at least some money to main street (the real economy) which shouldincrease profitability (see above) and the velocity of money (which is at 60-year lows).These positive effects should last throughout the first half of 2018, taking the stock market higher.However, after that, the $1.2 trillion which will have to be borrowed is likely to affect rates, flatten the 10-year minus 2-year differential, and start the countdown to recession.

We say that the tax-cut and deficit spending are ill-timed because these actions should have been implemented ten years ago at the bottom of the business cycle when interest rates were low, and the economy needed stimulating, not near the end of a recovery when rates and profits are already rising. The market will enjoy the party while it can, but it has the feel of a “blow-off” top in the making.We shall see!




Equities

Sentiment
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The put-to-call ratio continues to show a down-spike which is consistent with of a local top (chart below).

The SPX has bounced to the upper trendline as the VIX dropped below 20. We expect further volatility in the VIX (although not to the recent extremes) and the SPX to test the 2600 zone (chart below).

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Although the Rydex Bear:Bull asset ratio has spiked up from historically low levels, the 36 MA has yet to budge (chart below).

Technical
The long-term technical averages are starting to look tired, and while no warning signs have developed at this point (8 MA still above 12 MA), the ADX trend (black line), and the bullish and bearish momentum (green and red lines, respectively) have started to back away from extended levels (chart below). If the 8 MA crosses below the 12 MA, then we have to consider the correction being bigger and lasting longer than anticipated. At this time-scale, there are still no warning flags (chart below).

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Fundamentals
The 10-y minus 2-y differential was lowered this past week from 0.78 to 0.66 and continues to maintain an overall slope that would see an inversion in the second half of 2018. That would imply a recession could start sometime in 2019.

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Oil
We closed our short position in USO mid-week because it bounced off support and our hedge call option only had one week to expiration.

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Gold
Since our mid-week gold update, gold has risen on the higher than anticipated CPI, and in negative correlation with the dollar and the USD/JPY FOREX pair. Even though rates have continued to rise, the dollar has continued to weaken, and gold has maintained its negative correlation to the dollar. The dollar may have put in a double bottom, and the USD/JPY pair is oversold on the stochastic, giving both markets technical reasons to rally this coming week, which in turn, would put pressure on gold. (charts below)

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Gold seems to have over-reacted to the small uptick in the TIP etf, highlighting the fact that inflation expectations are not as high as gold’s price would assume (chart below).

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We wish our subscribers a profitable week ahead and ask that email be monitored for Trade Alerts.

Regards,

ANG Traders

Join us at www.angtraders.com

Forty years of private equity trading, and still learning.

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