Additional Risks to Weigh

For nearly a decade, we have been concerned with the distortive impact of monetary policy on the markets. Currently, our four measures of long-term market valuation are in their highest quintiles, levels associated with negative 1, 5 and 10 year returns. While this is problematic and requires investors to adjust their way of thinking about risk management, equities remain the only game in town for a majority of investors until interest rates begin to normalize. This does not preclude markets correcting, however.

The S&P 500 has corrected a number of times during periods of interest rate and even more overt quantitative ease. In this environment of overvalued markets, sentiment becomes the critical element to gauge, since investors' ability to determine risk is also distorted.

Here are two problematic items for the broad market advance to consider short-term: Volatility and Leverage.

The focus on the VIX as a measure of risk is often incomplete as they say in option land. SKEW measures recently reached significant highs again; levels associated with 'outlier performance', meaning negative market action beyond 2 standard deviations.

Another way sentiment can be seen is in the NYSE margin balance reaching the second highest ever reading; the highest being October 2014. While this is not a timing indicator, this amount of leverage sits heavily on the scale of market risks. Consider that while it is frequently discounted as an old-fashioned metric in a world of global derivatives, it could perhaps be viewed as the more tangible tip of an otherwise incomprehensibly large leverage iceberg made up of global derivatives.

As to how this relates to equities, we have consistently seen a market dynamic where trading is fast on the exits, accompanied by volume, followed by a rapid inflow that takes out the shorts, then relative value traders and others, finally followed by bond market refugees who sell utilities and healthcare shares to catch the top of a momentum trade in cyclicals. Perhaps the more significant cause of the overall sluggish inflows is due to the largest portion of new liquidity moving into stocks being from corporate buybacks. Its steady, but slow and feeds into markets that have tended to become extended. All of this combines in a market structure technicians call a rising wedge. Metaphorically, the market paints itself into a corner, then corrects.

So intermediate-term, the markets need a catalyst if it is to continue higher (invalidating the rising wedge) without some sort of intermediate-scale correction. Earnings are reported as slowing, in-line with international sales (global growth) slumping.



Steven Charest Managing Director, Chief Market Strategist

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