Normally we get significant rallies from a wearing off of (elevated) fear as investors put their sidelined cash back into the market. It helps if interest rates are falling or at least stable. We have defined fear as a version of Vix and though it’s better for it to be elevated, it can be equally as good to be close to the last time fear spiked. I then count forward to see the number of days since that spike. That is labeled the “PTW” or post-trauma window.
We can see here, two trauma events since last September. The last time we had such a large period after an event (without new trauma) was October of 2017. Returns were still positive, but they were nothing like the gains we saw in September 2017 or late Nov. – Dec. 2017 when the memory of higher volatility was still fresh. It’s always a good idea to hold your position and wait for a trailing stop to be broken because we can and do often see follow through even after volatility plunges for an extended period.
The historical record is quite clear – when we get more than 35 days beyond an “event” we usually need help from a bond rally or we need another (synthetic) Vix spike.
This chart shows you the market versus the level of the daily equity fuel gauge going back to last summer. It’s not perfect since the market failed to rally in August as expected and weaker gauge levels didn’t lead to declines in October or July. 2017 was a difficult year for the gauge because we had a significant exogenous factor to consider: tax cuts on corporations. The probability that these cuts would pass was the driving force for the rally and it trumped all other issues. It was better to wait for uncertainty over the passage to rise but there was an optimism that permeated the markets during October and July that was relentless. It is reasonable and logical to account for a new variable that is not in the gauge and make appropriate adjustments. I frequently mentioned this in my daily gauge update (email).
As we hit 2018 with all this momentum behind us and the prospective economic benefit of those cuts on GDP growth yet to come, we may well see this rally continue. The difficulty is that we have now reached a point where we have no fuel in the tank. There are few investors waiting on the sideline and interest rates are rising. Good returns are rarely offered to the crowd who get in late to a trend.
If you are bullish now you must have a new reason – something that is distinctly abnormal like:
- A surprising boost in (non-inflationary) GDP from the tax cuts.
- A complete detente with North Korea or
- The complete exoneration of Trump with the regard to obstruction of justice, money laundering and election collusion with Russia.
None of these things are factored into the Paratrade gauges and we must always be aware of, and make adjustments to factor models that fail to account for anomalous relevant factors.