May

31

The long expected break-out to new all time highs proved to be the real deal, and not the obligatory fbo/bull trap we have grown accustomed to enduring. The market quickly reached escape velocity and extended it's historical move, with a strong second day and even added more distance as the eminis were marked up throughout the week into the last day-of-the-month. With consistent positive returns generated on Fridays and Mondays it appears, this timeframe is a sine quo non for continued bullish momentum. Equity only p/c ratios are all on a buy signal, and market breadth is bullish also, which lends positive confirmation to the breakout. The continued low volatility situation has received much press, and no doubt, signals an overbought condition, but it is not a sell signal. That being said, the market is good, and is headed much higher; but is overbought. This means there is a high likelihood that the market will experience a sharp, but short-lived correction at any time. However, a sell-off should be greeted with open arms and both hands, as an opportunity to initiate or add to a long position. As reported by trim tabs, savings accounts remain the most popular destination for investor money and saw $139 billion flow into them in the first four months of 2014, exceeding the $77 billion inflow into all equity funds. So with the taper winding up and qe winding down, the next impetus for higher prices may just be the (fomo) fear-of-missing-out trade, as retail money inevitably chases the market higher.

As we say farewell to May and welcome in June, we should keep in mind, that the last trading day of the month plus the first four days of the following month are the best performing days of the month. Nevertheless, the economic calendar is busy next week, with china pmi, the ecb meeting on thursday, and and the employment situation on Friday; and any of these events or others, could provide the catalyst for a sharp sell-off.

It still appears to me that the current rally has been fueled by lower interest rates, which was the result of the big yield grab in both u.s. and European bonds. money flowed out of the euro into bonds ahead of the ecb meeting while the rally was further fueled by bad short bond positions. Nothing has changed valuation-wise since last year, other than the fact, that the market as a whole, is growing more expensive; but with rates falling from 3% to less than 2.5% the ratio of earnings yield to bond yield is being dynamically maintained. Since the crash, the difference between the 10 year yield and the dividend yield has been shrinking compared to the historical norm. When this distance is negative, it is only natural that money moves out of treasuries and into blue chips (dividend stocks). It is interesting to see that this move reversed when the gap between treasury yields and dividend yields reached close to 2% - the current ratio is 0.60%. For a reversion to 2 % to come about, dividends would have to stay flat or fall while interest rates would have to rise to at least 3-3.5%. However, as long as treasuries keep rallying and interest rates keep falling, equities will remain undervalued and continue to rally. It is interesting to note that the money flow into equities was weak today, which is not normal for a Friday, especially at the end-of the month. Low volatility stocks outperformed their high beta counterparts and the utility sector was uncharacteristically strong for an up-day in equities. This supports the theory that investors are looking for yield and not growth.

It is also interesting to note, that an oversold spot $vix with a steep contango in the vix futures used to mean that smart money was betting on higher volatility in the near future– and they were usually right. But since 2008, and especially since the inception of the VIX exchange traded products in 2009, the steep contango has not necessarily preceded equity sell-offs. This phenomena exists even with the vix at seemingly oversold levels with the attendant expectation for mean reversion. This is because the volatility products lose money when they roll their positions before expiration to maintain exposure. Etfs are forced to roll long positions into more expensive deferred contracts… on the other hand traders are more-than-happy to take the other side of the trade, and continue to sell-the vol-and-roll their short positions, because it still remains profitable.


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