Buckle Up, Volatility Is Coming
The Ivory Hill RiskSIGNAL is still red and we are sitting on roughly 74% cash (since January) for our noninstitutional clients.The most important technical levels are hinting at a further advance in stocks.BUT, market conditions are signaling, that we are far from a bottom.
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Buckle Up, Volatility Is Coming
Everybody in the world is a long-term investor until the market goes down. - Peter Lynch
The Ivory Hill RiskSIGNAL is still red, and we are sitting on roughly 74% cash. As you know, our signals flipped red in January, so we moved our non-institutional clients to 60%-70% cash.
The S&P 500 notched its highest close since September and broke out through its key short-term resistance level at 4,008, leaving the near-term path of least resistance higher as we approach the final month of 2022.
The chart below is a little crowded, but the most important technical levels to watch right now are the Fibonacci levels based on the drop from August to October. The 78.6% level at 4,149 is the next target for the S&P 500 to continue to rally.
Thanksgiving week is typically a week of low trading volume and a soft rise in stocks. This happened again this year, but the way that current market conditions are positioned tells us that investors are still hesitant to jump back into this market (and I don't blame them).
Market conditions are saying that we should expect increased volatility in the coming weeks and months. Why do I care about volatility? because volatility is predictable and is associated with down markets.
Let's take a look at a few sectors and asset classes relative to each other to see if we can interpret what the underlying market conditions might be signaling about the future direction of how much risk investors are willing to take in this market.
The below charts are all price ratios that show the underlying trend of the numerator relative to the denominator. A rising price ratio means the numerator is outperforming (up more/down less) the denominator. A falling price ratio means the numerator is underperforming relative to the denominator.
Chart 1. Utilities are telling us increased volatility is likely
The top chart above shows that utility stocks have been rising since late last year, while the bottom chart shows the S&P 500 has trended downward.
Why does this matter? This matters because, within the stock market, the utilities sector is considered to be the most defensive (less risky) given that we expect people will continue to pay for their electricity and water despite deteriorating economic conditions.
When the utilities sector outperforms, it usually means that investors are concerned about increased recession risks and are shifting their portfolios away from moderate-to-high-risk stocks and toward less risky stocks to provide downside protection.
If utilities continue to show outperformance, as they have for a couple weeks now, it could be signaling a significant shift in market sentiment.
Chart 2. Lumber is also telling the same story
Here is another price ratio chart showing lumber prices relative to gold prices (top chart). This is one of my favorite intermarket signals to follow because it doesn't move that often, so when it does, you should pay attention. While it does tend to head-fake every now and then, it is more right than wrong.
The idea behind this ratio is that when the economy is doing well, lumber prices go up because there is an increased demand for building houses.
Lumber is used the most in the housing market, where a stronger economy usually means more home building. In turn, this makes lumber prices go up.
On the other hand, as conditions break down and traders seek safety, demand for gold typically rises. Gold isn't really a defensive hedge, as it is an uncorrelated asset rather than a negatively correlated one. Still, it does typically behave like a defensive asset, so that is why the theory behind this uses gold as the defensive proxy.
Bottom line, lumber is in a downward trend, which means less building, which means a declining housing market, which means our economy is still showing declining growth.
Chart 3. Bonds are showing signs of life again
After about a year of frustrating declines, the bond market is showing signs of life again. As a recession still seems likely to happen (officially) at some point in the next year, inflation and the cryptocurrency market will be the main reasons why bonds keep going up.
The way that treasuries have behaved over the last month is suggesting that bond traders are thinking about a recession, which could be a bullish sign for treasuries going forward.
History never repeats itself, but it does often rhyme. - Mark Twain
We could be approaching a decisive point in this cycle. If underlying conditions continue to breakdown while treasuries manage to sustain a rally.
We could be in for a catastrophic collapse in stock prices while treasuries rally hard.
This same dynamic happened in 2008. The below chart shows that long-term treasuries had an absolute face-ripper rally while stocks crashed another 50%.
The Ivory Hill RiskSIGNAL is red, and market conditions are all singing the same song.
If we keep seeing a negative correlation between stocks and bonds and confirm it with falling lumber prices and utilities doing better than stocks, that's the market firing a red star cluster, which means stocks may be in for a wild ride down.
I know I have been a broken record all year with this closing, but let's review what we need to see in order for us to even start thinking "about thinking" about a bottom.
We need more fear!
We need to see the fear index spike because no bear market has ever bottomed without the VIX blowing out to 45 or higher. The VIX hasn't moved all year likely because institutional investors and pension plans have "PTSD" from 2018, and 2020, and they are not hedging their bets with options because they are completely out of the market, putting downward pressure on the VIX despite increased selling in equities.
The same dynamic occurred in 2002 and 2008, so we need to be patient. Again, I strongly believe that this is the most anticipated global recession in history, and that means it will take longer to bottom than anyone has the patience for.
The yield curve needs to revert, and stocks need to crash.
The yield curve is now inverted the most since 1981, when we had the worst economic downturn in the United States since the Great Depression.
As you can see, when the curve reverts, that is the sell signal because stocks have crashed every time the yield curve has reverted following an inversion.
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Outperformance is achieved through the avoidance of major market crashes.
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Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President
8400 Normandale Lake Blvd, Suite 920, Bloomington, MN 55437