Current Thinking

The End is Near!..or is it?- Part One

A blog by Scott Stone, CIO, Senior Vice President – October 21, 2014

For much of 2014, several leading market pundits and even professional portfolio managers have been warning that the US equity market was headed for a major catastrophe. Ebola virus, Russian aggression in the Crimea, ISIS in Syria, Iran’s nuclear ambitions, the upcoming US elections – all of these and more have been labeled at one time or another as reasons that the US equity markets are at risk for a sell-off. The recent string of high-profile losses posted by the Dow Jones Industrial Average and the S&P 500 would seem to indicate these predictions are indeed coming true. From September 18th, when the S&P 500 last closed on an all-time high, the market fell over 125 points to close one month later on October 17th at 1886.76, for a 6.6% decline.

That is, the market fell back to where it had been in late May.

As corrections go, this latest one is mild. The question on investors minds though, is whether or not this is just the beginning. Are we really headed for another meltdown, like 2008? Or is this something else?
Here at Pentegra, we focus on several indicators to help us judge where we are in the equity market cycle. One is the VIX, or volatility index. Specifically, this Chicago Board Options Exchange Index measures expected future volatility of the S&P 500 based on the weighted average implied volatility of multiple options traded on the CBOE. In the last week, this measure spiked above 20 for only the second time in 2014, and the fifth time since the end of 2011. Historically, a sustained VIX in excess of 20 has indicated a ‘crisis period’ in the equity markets – the last time being from July of 2011 to January of 2012. This was the period of the Greek debt default and the US Budget standoff in Washington. There was also a brief period in the middle of 2010 when the VIX held above this level, also caused by European sovereign debt worries. Of course, the most severe period in recent history was during the financial crisis in 2008, when the VIX spiked above 20 – then 40 and then up to 80! During these periods, the markets tend to rally when the VIX is below 20, or has spiked above 20 but his heading downward rapidly to the 20 level. As of Monday October 20th, the VIX has dropped back below 20, to 18.65.

Another set of indicators that seem effective in predicting rough equity markets are credit spreads in the fixed income world. In the last several major equity downturns, credit spreads increased dramatically before the equity market cracked. The logic behind looking at this indicator is that it’s another measure of the market’s tolerance of risk; if the spreads are increasing, investors of all stripes are demanding more compensation for the risks they are taking with their exposure to US corporations. So what do credit risk spreads tell us? The investment grade 5-year CDX index spread currently stands at 70 basis points, or .70% per annum in excess of risk-free rates. During the 2008 crisis, this rate ballooned to over 250 basis points. As recently as late 2012, it remained above 100 basis points. Although this rate was as low as 56 basis points last month, the increase isn’t dramatic enough to set off any alarms – yet. High Yield spreads tell a similar story – up from recent lows, but not enough to warrant concern and definitely not ‘spiking’ as they did in 2008 or 2011.

Another indicator we believe to be effective is the correlation between stocks and US Treasury bond prices. The more negative and strong the correlation, the more the markets have shifted to a ‘risk-off’ mentality. The rolling 60-day reading looks today as it did 60 days ago, and it’s even less threatening than it was in the first quarter of the year. In short, investors are not flocking to safety in tandem with their recent flight from risk; thus, this indicator is also benign.

In short we see recent US equity market sell-offs as a routine correction for a market that hasn’t suffered any serious setbacks for several years – at least, so far. If market volatility stays high, credit spreads suddenly increase dramatically and the stock/bond correlation spikes deep into negative territory, we will change our views.