Market Volatility and the S&P 500

It was clear from investment managers’ comments at the start of the year — even Jeremy Grantham’s meltup — that most expected a rally followed by an adjustment later in the year or early next year.

Valuations are high and the focus has started to swing away from making further gains and towards protecting existing profits. The size of this week’s candles reflect the extent of the panic as gains patiently accumulated over several months evaporated in a matter of days.

S&P 500

Volatility spiked, with the VIX jumping from record lows to above the red line at 30.

S&P 500 Volatility (VIX)

VIX reflects the short-term, emotional reaction to events in the market but tends to be unreliable as an indicator of long-term sentiment. I prefer my own Volatility indicator which highlights the gradual change in market outlook. The chart below shows how Volatility rose gradually from mid-2007, exceeding 2% by early 2008 then settled in an elevated range above 1% until the collapse of Lehman Bros sparked panic.

S&P 500 in 2008

The emerging market crisis of 1998 shows a similar pattern. An elevated range in 1997 as the currency crisis grew was followed by a brief spike above 2% before another long, elevated range and then another larger spike with the Russian default.

S&P 500 in 1998

The key is not to wait for Volatility to spike above 2%. By then it is normally too late. An alternative strategy would be to scale back positions when the market remains in an elevated range, between 1% and 2%, over several months. Many traders would argue that this is too early. But the signal does indicate elevated market risk and I am reasonably certain that investors with large positions would prefer to exit too early rather than too late.

So where are we now?

Volatility on the S&P 500 spiked up after an extended period below 1%. If Volatility retreats below 1% then the extended period of low market risk is likely to continue. If not, it will warn that market risk is elevated. Should that continue for more than a few weeks I would consider it time to start scaling back positions.

S&P 500 in 2018

Only if we see a further spike above 2% would I act with any urgency.

Black Monday, October 1987

Cross-posted from

What caused the Black Monday crash of 1987? Analysts are often unable to identify a single trigger or cause.

Sniper points to a sharp run-up in short-term interest rates in the 3 months prior to the crash.

3 Month Treasury Bill Rates

Valuations were also at extreme readings, with PEmax (price-earnings based on the highest earnings to-date) near 20, close to its Black Friday high from the crash of 1929.

S&P 500 PEmax 1919 - 1989

Often overlooked is the fact that the S&P 500 was testing resistance at its previous highs between 700 and 750 from the 1960s and 70s (chart from macrotrends).

S&P 500 1960 - 1990

A combination of these three factors may have been sufficient to tip the market into a dramatic reversal.

Are we facing a similar threat today?

Short-term rates are rising but at 40 basis points over the last 4 months, compared to 170 bp in 1987, there is not much cause for concern.

13-week T-Bill rates

PEmax, however, is now at a precipitous 26.8, second only to the Dotcom bubble of 1999/2000 and way above its October 1987 reading.

S&P 500 PEmax 1980 - 2017

While the index is in blue sky territory, with no resistance in sight, there is an important psychological barrier ahead at 3000.

S&P 500

Conclusion: This does not look like a repetition of 1987. But investors who ignore the extreme valuation warning may be surprised at how fast the market can reverse (as in 1987) from such extremes.

Outlook for 2018

At this time of year we are usually inundated with projections for the year ahead, from predictions of imminent collapse to expectations of a record year.

We live in a world of uncertainty, where both extremes are possible, but neither is likely.

We are clearly in stage 3 (the final stage) of a bull market. Risk premiums are close to record lows. The yield spread between lowest investment-grade (Baa) bonds and equivalent risk-free Treasuries has crossed to below 2.0 percent, levels last seen prior to the 2008 global financial crisis. The VIX is also close to its record low, suggesting high levels of investor confidence.

Corporate Bond Spreads and VIX

Money supply continues to grow at close to 5.0 percent, reflecting an accommodative stance from the Fed. MZM, or Zero Maturity Money, is basically M1 plus travelers checks and money market funds.

Zero-Maturity Money

Inflationary forces remain subdued, with average hourly wage rates growing at below 2.5 percent per year. A rise above 3.0 percent, which would pressure the Fed to adopt a more restrictive monetary policy, does not appear imminent.

Average Hourly Wage Rates

Tax relief and higher commodity prices are likely to exert upward pressure on inflation in the year ahead. But the Fed’s stated intention of shrinking its balance sheet, with a reduction of $100 billion in the first 12 months, is likely to have an opposite, contractionary effect.

The Leading Index from the Philadelphia Fed gave a bit of a scare, dipping below 1.0 percent towards the end of last year. But data has since been revised and the index now reflects a far healthier outlook.

Philadelphia Fed Leading Index

A flattening yield curve has also been mooted as a potential threat, with a negative yield curve preceding every recession over the last 50 years.

Yield Differential 10-Year compared to 2-Year and 3-Month Treasuries

A yield differential, between 10-year and either 2-year or 3-month Treasuries, below zero would warn of a recession. When long-term yields fall below short-term yields financial markets stop working efficiently and bank lending tends to contract. Banks, who generally borrow at short-term rates and lend at long-term rates, find their margins are squeezed and become strongly risk-averse. Contracting lending slows the economy and normally leads to recession.

But we are some way from there. If we take the last cycle as an example, the yield curve started flattening in 2005 (when yield differentials fell below 1 percent) but a recession only occurred in 2008. The market could continue to thrive for several years before the impact of a negative yield curve is felt. To exit now would seem premature.

PEMAX second highest peak in 100 years

I published a chart of PEMAX for the last 30 years on Saturday. PEMAX eliminates the distortion caused by cyclical earnings fluctuations, using the highest earnings to-date rather than current earnings. The idea being that cyclical declines in earnings reflect a fall in capacity utilization rather than a long-term drop in earnings potential.

Since then I have obtained long-term data dating back to 1900 for the S&P 500 and its predecessors, from

PEMAX for November 2017 is 24.34, suggesting that stocks are over-valued.


Outside of the Dotcom bubble, at 32.88, the current value is higher than at any other time in the past century. PEMAX at 24.34 is higher than the peak of 20.19 prior to the 1929 Black Tuesday crash, and higher than the 19.8 peak before Black Monday in 1987.

This does not mean that a crash is imminent but it does warn that investors are paying top-dollar for stocks. And at some point values are going to fall to the point that sanity is restored.

Robert Shiller’s CAPE ratio

Here is Robert Shiller’s CAPE ratio for comparison. CAPE attempts to eliminate distortion from cyclical earnings fluctuations by comparing current index values to the 10-year average of inflation-adjusted earnings.

Shiller CAPE 10 Ratio

While this works reasonably well most of the time, average earnings may be distorted by the severity of losses in the prior 10 years.

You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.

~ Warren Buffett

CAPE v PEMAX: How hot are market valuations?

Robert Shiller’s CAPE ratio is currently at 32.17, the second-highest peak in recorded history. According to, prior to the Black Tuesday crash of 1929 CAPE had a reading of 30. The only peak with a higher reading is the Dotcom bubble at 44.

Shiller CAPE - click to enlarge

Click here to view at

Shiller’s CAPE, or Cyclically Adjusted PE Ratio to give it its full name, compares the current S&P 500 index value to the 10-year average of inflation-adjusted earnings. The aim is to smooth out the earnings cycle and provide a stable assessment of long-term potential earnings.

But earnings have fluctuated wildly in the past 10 years, and a 10-year average which includes severe losses from 2009 may not be an accurate reflection of current earnings potential.

S&P 500 Earnings

The dark line plotted on the above chart reflects the highest earnings to-date, or maximum EPS. The market often references this as the current, long-term earnings potential, in place of cyclical earnings.

The chart below compares maximum EPS (the highest earnings to-date) to the S&P 500 index. The horizontal periods on max EPS reflect when cyclical earnings are falling.

S&P 500 and Peak Earnings

It is clear that the index falls in response to cyclical fluctuations in earnings (the flat periods on EPS max). But it is also clear that earnings quickly recover to new highs after the index has bottomed. In Q1 of 2004 after the Dotcom crash and in Q3 of 2011 after the 2008 global financial crisis.

The next chart plots the current index price divided by maximum earnings to-date. I call it PEMAX. When earnings are making new highs, as at present, PEMAX will reflect the same ratio as for trailing 12-month PE. When earnings are below the previous high, PEMAX is lower than the trailing PE.


What the chart shows is that, outside of the Dotcom bubble, prices are highest in the last 30 years relative to current earnings potential. The current value of 22.56 is higher than at any time other than the surge leading into the Dotcom crash.

The peak value during the Dotcom bubble was 30.19 in Q2 of 1999. The highest value in the lead-up to the GFC was 20.23 in Q4 of 2003.

Does the current value of 22.56 mean that the market is about to crash?

No. The Dotcom bubble went on for two more years after reaching 22.80 in Q3 of 1997. The present run may continue for a while longer.

But it does serve as a reminder to investors that they are paying top-dollar for stocks. And at some point values are going to fall to the point that sanity is restored.

The four most expensive words in the English language are “this time it’s different.”

~ Sir John Templeton

Australian banks under selling pressure

The ASX 300 Banks index are a major drag on the broad market index. Having respected resistance at 8500, a test of primary support at 8000 is likely. Twiggs Trend Index peaks below zero warn of strong selling pressure.

ASX 300 Banks

Return on equity is falling.

Australian Banks Return on Equity

A combination of narrow interest margins.

Bank Net Interest Margins

Soaring household debt.

Bank Net Interest Margins

And rising capital requirements as APRA desperately tries to protect their glass jaw.

Bank Capital Ratios

Don’t let the ratios fool you. They are based on risk-weighted assets. Common Equity Tier 1 (CET1) leverage ratio for at least one of the majors is as low as 4.0 percent.

China is the biggest credit bubble in the world today | Crescat Capital

From Nils Jenson at Crescat Capital:

History has proven that credit bubbles always burst. China by far is the biggest credit bubble in the world today…….

The Bank for International Settlements (BIS) has identified an important warning signal to identify credit bubbles that are poised to trigger a banking crisis across different countries: Unsustainable credit growth relative to gross domestic product (GDP) in the household and (non-financial) corporate sector. Three large (G-20) countries are flashing warning signals today for impending banking crises based on such imbalances: China, Canada, and Australia….

The trouble with credit bubbles is they always burst. The problem is we don’t know when. “Imminent” could mean next week or it could mean in 3 years time. Keep a close watch on the PBOC for signs that it has run out of options. They will kick the can down the road for as long as possible, but the time will come when that is no longer viable.

Great Analysis, worth reading the entire report: Crescat Capital Quarterly Investor Letter Q2 2017 | Crescat Capital

This oil price rally has reached its limit – On Line Opinion

Good summary of the oil market by Nicholas Cunningham – posted Friday, 4 August 2017:

There are several significant reasons why oil prices have regained most of the lost ground since the end of May….

  1. OPEC cuts;
  2. US shale expansion is slowing;
  3. Several OPEC members have promised deeper cuts; and
  4. Drawdowns in U.S. crude oil inventories suggest the market is finally rebalancing.

But inventories are still high, not just in the U.S. And the US (despite shale slowing), Libya and Nigeria are all expected to increase output.

Also, the recent rally is largely attributable to short-covering rather than hedge funds taking fresh long positions.

But there is a wild card:

The one variable that could upend all market forecasts is Venezuela, which has been in economic turmoil for quite some time but is entering a new phase of crisis. The involvement of the U.S. government, which is retaliating against Venezuela for what it argues is a step towards dictatorship, threatens to accelerate the oil production declines in the South American nation.

If Venezuela sees its exports disrupted in a sudden way, the ceiling for oil prices in 2017 could be quite a bit higher than everyone expects at the moment. Otherwise, there is not a lot of room on the upside for oil prices in the short-term.

…it could go up, it could go down, but not necessarily in that order.

Using fundamentals to predict short-term cycles is at best a 50/50 proposition. It’s normally best to stick to technicals (for short time frames). Looks like a secondary rally in a bear market.

Nymex Light Crude

Source: This oil price rally has reached its limit – On Line Opinion – 4/8/2017

Boris Johnson wrong to link Australia’s economic growth to the resources boom

In criticizing Boris Johnston, Ross Gittins at The Herald, unwittingly highlights the hubris of the economics profession:

When Boris Johnson, Britain’s Foreign Minister, visited Oz lately, he implied that our record 26-year run of uninterrupted economic growth was owed largely to the good fortune of our decade-long resources boom.

Johnson, no economist, can be forgiven for holding such a badly mistaken view – especially since many Australian non-economists are just as misguided. They betray a basic misconception about the nature of macro-economic management and what it’s meant to do.

It’s clear that Johnson, like a lot of others, hasn’t understood just why it is that 26 years of uninterrupted growth is something to shout about.It’s not that 26 years’ worth of growth adds up to a mighty lot of growth. After all, most other countries could claim that, over the same 26-year period, they’d achieved 23 or 24 years’ worth of growth.

No, what’s worth jumping up and down about is that little word “uninterrupted”. Everyone else’s growth has been interrupted at least once or twice during the past 26 years by a severe recession or two, but ours hasn’t.

That’s the other, and better way to put it: we’ve gone for a record 26 years without a severe recession.But now note that little word “severe”. As former Reserve Bank governor Glenn Stevens often pointed out, we did have a mild recession in 2008-09, at the time of the global financial crisis, and earlier in 2000-01.

So, yet another way to put the Aussie boast is that we’ve gone for a period of 26 years in which the occasional increases in unemployment never saw the rate rise by more than 1.6 percentage points before it turned down again.

What you (and Boris) need to understand about macro-economic management is that its goal isn’t to make the economy grow faster, it’s to smooth the growth in demand as the economy moves through the ups and downs of the business cycle.

This is why macro management is also called “demand management” and “stabilisation policy”. These days, the management is done primarily by the Reserve Bank, using its “monetary policy” (manipulation of interest rates), though both the present and previous governor have often publicly wished they were getting more help from “fiscal policy” (the budget).

When using interest rates to smooth the path of demand over time, your raise rates to discourage borrowing and spending when the economy’s booming – so as to chop off the top of the cycle – and you cut rates to encourage borrowing and spending when the economy’s busting – thereby filling in the trough of the cycle.This is why the economic managers find it so annoying when the Borises of this world imagine that the decade long resources boom – the biggest we’ve had since the Gold Rush – must have made their job so much easier.Just the opposite, stupid. Introducing a massive source of additional demand in the upswing of the resources boom made it that much harder to hold demand growth steady and avoid inflation taking off.

But then, when the boom turned to bust, with the fall in export commodity prices starting in mid-2011, and the fall in mining construction activity starting a year later, it became hard to stop demand slowing to a crawl.

We’re still not fully back to normal.This is why the macro managers’ success in avoiding a severe recession for 26 years is a remarkable achievement, and one owed far more to their good management than to supposed good luck (whether from China or anywhere else).

But what exactly is the payoff from the achievement? Twenty-six years in which many fewer businesses went out backwards than otherwise would have.

Twenty-six years in which many fewer people became unemployed than otherwise, and those who did had to endure a far shorter spell of joblessness than otherwise.

The big payoff from avoiding severe recessions – or keeping them as far apart as possible – is to avoid a massive surge in long-term unemployment that can take more than a decade to go away – and even then does so in large part because people give up and claim disability benefits or become old enough to move onto the age pension.

Dr David Gruen, a deputy secretary in the Department of the Prime Minister and Cabinet, has demonstrated that, though the US economy had a higher proportion of its population in employment than we did, for decades before the global crisis, since then it’s been the other way around.”The key lesson I draw from this comparison is that the avoidance of deep recessions improves outcomes in the labour market enormously over extended periods of time,” he concluded.

“What you (and Boris) need to understand about macro-economic management is that its goal isn’t to make the economy grow faster, it’s to smooth the growth in demand as the economy moves through the ups and downs of the business cycle.”

Well how’s that been working for ya, Ross, over the last three decades. Attempts at smoothing the global economic cycle (primarily led by the US Fed) have achieved two of the most severe recessions in the last century. Smoothing out the natural creative destruction of the capitalist system allows imbalances to build. Periods of uninterrupted growth may be longer, but when the dam wall breaks, as it did in 2008, the severity of the backlash when the economy tries to restore equilibrium (or “balance” as us non-economists like to describe it) threatens to break the very foundations of the financial system.

Not exactly a time for high-fives and self-congratulation for the economics profession. To me economics should focus on the study of unintended consequences, of which there are many examples in the last 30 years.

The presumption that macro-economists can improve on the performance of an economy by constant intervention has clearly been demonstrated to be a fallacy.

Mechanical engineers in the 1800s were confronted with a similar problem when building large steam engines that worked under variable load. Attempts to smooth the load using a governor, adjusting braking in response to detected acceleration or deceleration was the obvious solution. But these governors created a feedback loop — highlighted by James Clark Maxwell in his famous 1868 paper On Governors to the Royal Society of London — that made these giant steam engines prone to self-destruct.

Constant interference with market forces in an effort to smooth economic growth has a similar effect on the economy. The lag between an actual event and its measurement, reporting and subsequent monetary policy response is susceptible to creating a feedback loop that amplifies the cycle instead of smoothing it, causing the system to self-destruct.

Economists on graduation should be required to make a pledge similar to the Hippocratic oath of the medical profession which starts: “First do no harm….”

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.

~ Mark Twain (Samuel Clemens)

Source: Boris Johnson was wrong to link Australia’s economic growth to the resources boom

Nasdaq and S&P500 meet resistance

July labor stats are out and shows the jobless rate fell to a 16-year low at 4.3%. Unemployment below the long-term natural rate suggests the economy is close to capacity and inflationary pressures should be building.

Unemployment below the long-term natural rate

Source: St Louis Fed, BLS

But hourly wage rates are growing at a modest pace, easing pressure on the Fed to raise interest rates.

Hourly Wage Rates

Source: St Louis Fed, BLS

Fed monetary policy remains accommodative, with the monetary base (net of excess reserves) growing at a robust 7.5% a year.

Hourly Wage Rates

Source: St Louis Fed, FRB

Our forward estimate of real GDP — Nonfarm Payroll * Average Weekly Hours — continues at a slow but steady annual pace of 1.79%.

Real GDP compared to Nonfarm Payroll * Average Weekly Hours

Source: St Louis Fed, BLS & BEA

The Nasdaq 100 has run into resistance at 6000. No doubt readers noticed Amazon [AMZN] and Alphabet [GOOG] both retreated after reaching the $1000 mark. This is natural. Correction back to the rising trendline would take some of the heat out of the market and provide a solid base for further gains. Selling pressure, reflected by declining peaks on Twiggs Money Flow, appears secondary.

Nasdaq 100

The S&P 500 is also running into resistance, below 2500. Bearish divergence on Twiggs Money Flow warns of moderate selling pressure but this again seems to be secondary — in line with a correction rather than a reversal.

S&P 500

Target 2400 + ( 2400 – 2300 ) = 2500