Macro-Strategist Says: Funeral Services for Volatility Premature; Second Half Different than First

Below excerpt courtesy of this a.m.’s edition of Rareview Macro’s “Sight Beyond Sight” macro-strategy newsletter.

Neil Azous, Rareview Macro LLC
Neil Azous, Rareview Macro LLC

“….We start the second half of 2014 well aware that over the last few years the second half of the year has had little resemblance to the first. Over the last three years, for example, we saw major changes from the first half to the second.

• 2013: Taper/no taper whipsaw in US Treasuries and Emerging Market Foreign Exchange
• 2012: Draghi “Do Whatever it Takes” and Japanese PM Abe’s Three Arrows
• 2011: EU debt crisis and US ratings downgrade

Therefore, we remain very open to the argument that something no one is thinking about could surprise the markets. We don’t know what that might be, and we not sure anyone else does either. By definition, it will be something way off the radar right now.

Someone asked us yesterday what our best fundamental reason is for continued US equity strength and low volatility.

Our answer is that conventional wisdom argues that the market is six months forward-looking. Six months from today is the first day of 2015. The consensus S&P 500 operating EPS for 2014 is $119 and with the last price ~1960 the P/E is ~16.5x. The EPS consensus for 2015 is $133. If the conventional wisdom is correct, in that the market is a discounting mechanism six months in advance, that means the P/E just dropped below 15 (i.e. SPX last price 1960 / 2015 EPS 133 = 14.7x) starting today. This does not take into consideration that consensus expectations are too high for next year or that this year could still be revised lower. Even so, the key point is that the argument that the market is overvalued just became weaker.

This is important to recognize as volatility is first and foremost driven by earnings. So unless there is meaningful deterioration at the corporate operating performance level, volatility can stay suppressed as investors remain very conditioned to geopolitical or exogenous shocks, and they don’t have much impact on the market.

At this point, if we were forced to guess the “unknown” that would trigger a true correction at the index level, a reduction in earnings forecasts and higher volatility, it would be a US recession. The takeaway from this is that volatility would fundamentally react to a growth and EPS downgrade.

Wouldn’t it be ironic if Obamacare was the cause of a shift in sentiment, and the consensus quickly shifted to a “recession scare”, right at the one-year anniversary to last October’s release, which also happens to coincide with this year’s mid-term elections? Since Obamacare was the root cause of the apocalyptic -2.9% GDP data in the first quarter a continuation in the second quarter can’t be ruled out…

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