Watch These Three Conditions


The extended holiday weekend provided ample time for me to catch up on reading the many market research reports that I intently follow. It seemed each led by addressing the obvious absence of any significant market correction since the U.S. fiscal cliff was resolved in early 2013.

I suspect raising concern is warranted regarding low volatility, complacency, and the potential for a correction, but I caution that investors allow market conditions to dictate when exactly they explore paring back exposure to risk assets.

Accordingly, let me share three conditions I am watching that would provide the evidence to warrant taking action to reduce risk.

1. D.C. Dysfunction Re-emerges

Year to date, our elected officials in Washington D.C. have been remarkably quiet. Having D.C. stay quiet on the markets is a great condition for risk asset appreciation. However, I place D.C. dysfunction very high on my list of conditions that could disrupt the rally. This weekend CNBC ran a story on the Obama administration seeking new regulations on Wall Street. Speaker John Boehner’s op-ed, whether correct or not, certainly brings forth the re-emergence of political tensions once again.  The midterm elections will be more contentious, particularly following House Majority Leader Eric Cantor’s primary defeat. Lastly, we have already had to deal with concerns related to Ukraine and Iraq this year; now I suggest looking much closer to home, as September 30 is the deadline for Congress to resolve three key issues:  Export-Import Bank, Discretionary Spending Renewal, and Department of Transportation Highway Bill.

2. Earnings Guidance and Price Reaction

During the upcoming earnings season, listen intently to management guidance for the end of 2014. Recent economic data suggests a sharp rebound in GDP from the first quarter’s dismal 2.9% contraction. Do CEOs share that optimism, and will they have the confidence to raise guidance accordingly?

Finally, earnings estimates have risen over the past month and a half. With expectation levels increasing, I will watch closely for the price reaction to strong earnings reports. Be alert to good earnings news that does not equal good price action. That would be a negative sign for continued risk asset appreciation.

3. Market Technical Indicators

I am keeping a close watch on the Japanese yen (Figure 1), which has been a strong indicator for the global risk asset rally since late 2012. Any appreciation above 100 is negative for risk and suggests a liquidation of the “carry trade.”

The technical formation for the S&P 500® Index (Figure 2) continues to present as pristinely bullish as has been witnessed since the mid to late 1990s. I have identified the 1925 level as a critical near-term point of reference. This level held support during a modest SPX decline in early June. A break back below 1925 would be negative for the overall SPX.

Low volatility seems to be on everyone’s mind. Use the 200-day moving average for the CBOE Volatility Index (VIX) (Figure 3) at 13.88 to signal an elevation in volatility. However, even with an elevation back above 13.88, the VIX would still signal favorable market conditions. A break above 13.88 raises my awareness; a rise above 18 signals the need for action.

Figure 1: Japanese Yen, October 1, 2012 to July 8, 2014

Source: Bloomberg

Figure 2: SPX Index, October 1, 2012 to July 8, 2014

Source: Bloomberg

Figure 3: CBOE Volatility Index, October 1, 2012 to July 8, 2014

Source: Bloomberg

Two Investment Ideas to Consider

Having given three market conditions to watch, let me close with two investment ideas for consideration.

  1. Exposure to hedge funds should be considered at these levels in order to tap the intellectual capital that can act swiftly to reduce risk if warranted.
  2. The consumer staples sector has underperformed this year. Select deals are beginning to unfold in the sector, as companies seek organic growth with a specific focus on emerging markets exposure. Yesterday’s Archer Daniels Midland (ADM) $3 billion purchase of Wild Flowers is an example, with the potential for stable earnings, increased M&A, and good value.

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.