The 'Fear Ratio' Signaling a Short-Term Risk to Stocks

The VIX-VXV ratio is extremely low after the S&P 500 Index (SPX) rallied well above pre-'Brexit' levels

by Joe Bell

Published on Jul 25, 2016 at 9:30 AM

Just four weeks ago, the S&P 500 Index (SPX - 2,175.03) was barely holding onto the round 2,000 level, after the U.S. stock market plummeted on the unexpected decision by Great Britain to leave the European Union. In an amazing turn of events, stocks not only retraced those short-term losses, but surged more than 8% higher over the subsequent three weeks to place the SPX at fresh all-time highs. The 2,100-2,120 area on the SPX had acted as staunch resistance for more than 19 months, but we finally managed to hold onto some momentum and put that region in the rearview mirror.

Schaeffer's Senior VP of Research Todd Salamone mentioned in last week's Monday Morning Outlook that there was a strong possibility of consolidation or a modest pullback in the days ahead. Well, we didn't experience a pullback, but the market was essentially flat for the week, squeaking out a gain of only 0.6% on low volume. After such a strong rally, short-term relative strength indicators are showing a market that is a little overheated. In that context, it was no surprise that equities took a breather for the week. Under the surface, technology, utilities, and healthcare stocks all had a pretty nice week. On the other hand, we saw energy, industrials, and consumer staples lag.

Speaking of the energy sector, one of the key developments last week was the strength of the PowerShares U.S. Dollar Index (UUP - 25.21). For the first time since reaching a peak in December 2015, UUP broke above a descending trendline connecting its recent string of lower highs. This breakout also coincided with a move above the round-number $25 level and its 200-day moving average.

UUP Daily Chart July 22

So what does all of this mean? If you remember any of the corporate earnings conference calls in 2014 and 2015, a repeated theme was how the incredibly strong U.S. dollar was acting as a headwind for energy stocks, dollar-denominated commodities, and multi-national companies that sell a lot of U.S. goods overseas. Just when they thought the dollar strength was subsiding, the greenback is back -- and could create speed bumps for companies hoping to turn around their performances during the second half of 2016.

I specifically mention the second half of the year because we are in the heart of earnings season, and earnings haven’t been that great during the first half of the year. In fact, the earnings of SPX companies, in aggregate, are expected to decline by 5.5% this quarter, relative to 12 months ago. The most interesting thing in regards to earnings expectations are how estimates have declined over the past several weeks, while the stock market has surged. This combination of higher prices and lower earnings means price-earnings (P/E) ratios are becoming more and more inflated.  The SPX's forward P/E ratio currently stands at about 18, which is higher than the long-term average and something to keep an eye on.

With the SPX sitting at all-time highs and perhaps preparing taking a breather, a couple of other indexes are at critical points. The Russell 2000 Index (RUT - 1,212.89) is looking to get a foothold above the round-number 1,200 level, which marked a short-term peak in November 2015. The 1,200 area is approximately double the October 2011 low of 601.71, as well. With RUT consolidating above this area after its strong rally in early June, the probabilities of clearing this region look high right now.

On the other hand, the Nasdaq Composite (COMP - 5,100.16) had a very nice week and seems to have won its battle with the 5,000 level. The outperformance in the tech-heavy index was helped by a large buyout early last week, when SoftBank Group announced a $32 billion cash offer to acquire UK-based ARM Holdings plc (ADR) (NASDAQ:ARMH) -- the world's leading semiconductor IP company --  representing a 43% premium over the stock’s market price.

COMP Daily Chart July 22

Besides earnings, the major talking point for market participants was the European Central Bank (ECB) announcement. The ECB reiterated that they would keep their interest rates for refinancing operations, marginal lending, and deposit facilities unchanged at 0.00%, 0.25%, and -0.40%, respectively. They also insisted that interest rates are expected to remain at lower levels for an extended period of time and well past when they stop making asset purchases. This type of news only serves to reinforce the price behavior we've seen from U.S. Treasuries over the past couple years, and more specifically, in 2016. Despite most analysts predicting U.S. interest rates were going to go higher and bond prices lower, the exact opposite has happened. While the SPX has rallied more than 6% this year, the iShares 20+ Year Treasury Bond ETF (TLT) has surged more than 15%. Even though rates in the U.S. are near rock-bottom levels, they are still some of the highest in the world, and we are still seeing money flow into these instruments.

TLT Daily Chart July 22

The one major short-term concern would be how low implied volatility is right now. Comparing the CBOE Volatility Index (VIX - 12.02) to the CBOE S&P 500 3-Month Volatility Index (VXV - 15.80), we are seeing a VIX/VXV ratio at its lowest level since December 2015. We see spikes in this ratio when there is a lot of short-term fear, which increases premiums for short-term options. The extremely low level of this ratio indicates there is an extremely low level of fear or worry in the immediate short-term. It is important to note that this type of complacency in December 2015 was followed by a short-term sell-off and three months of very volatile price action in U.S. equities. This is definitely a short-term risk for the market.

VIX VXV ratio July 22

Despite all of the short-term volatility, scary headlines, and uncertainty throughout this year so far, long-term buy-and-hold investors are still reaping the benefits of patience and remaining calm in the face of a market filled with fear. Todd Salamone has previously detailed in this space the amount of skepticism and fear we have seen at various short-term bottoms throughout the year. Despite some of the short-term concerns, it is hard to argue with a resilient market that has maintained its uptrend despite so many naysayers.

Looking ahead, we still have about three more weeks of heavy earnings reports. This week, such notable names as Texas Instruments (TXN), 3M (MMM), Caterpillar (CAT), McDonald's (MCD), Verizon (VZ), Facebook (FB), Twitter (TWTR), Ford Motor (F), Apple (AAPL), Alphabet (GOOG), and Amazon.com (AMZN) are among the companies set to report. On the other hand, it is set to be a relatively quiet week on the economic front, aside from the Federal Open Market Committee (FOMC) meeting, which will kick off Tuesday and conclude Wednesday -- though no change to monetary policy is expected this month.


Read more:

Indicator of the Week: What Happens After an S&P Snap-Back Rally?

The Week Ahead: Fed Decision Due; Apple, Facebook Highlight Tech Earnings

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