The Dow Jones Industrial Average last week returned to record territory for the first time since late January, vindicating bulls but also stirring memories of the February plunge that knocked the blue-chip average and the S&P 500 into correction territory.
Indeed, Jefferies analysts led by Sean Darby, chief global equity strategist, write in a Monday note that the current landscape is “similar to the February correction but with some redeeming features.” And those redeeming features, they said, are reason enough not to short the market.
So what looks familiar?
For one, investors are again extremely overweight on bets for volatility to continue falling and for Treasury prices to fall, lifting yields, across durations (see charts below). Also, Commodity Futures Trading Commission data indicate speculators are short gold to the most extended degree in 15 years, underlining heightened risk appetite, they said.
Investors might recall that bets that implied stock-market volatility—as measured by the Cboe Volatility Index VIX, +4.45% —would continue to fall were blamed for amplifying the February selloff. Carnage in exchange-traded products used to make short bets on the VIX caused a sharp spike in the volatility index, which briefly soared above 50. The VIX rose 6.8% Monday to 12.47, but remains well below its long-term average between 19 and 20 and is off more than 2% so far in September. For the year to date, it is up 13.9% after spending much of 2017 near all-time lows.
Second, while corporate credit spreads remain well-behaved, investors have been liquidating high-yield bonds for investment-grade corporate paper, the analysts said.
Third, the yield curve, a measure of the spread between short- and long-dated Treasury yields, continues to flatten, highlighting recession concerns, though the analysts noted that investors actually appear to be less focused on recession risk than they were six months ago.
Finally, the dollar is much stronger than a year ago, they said. The ICE U.S. Dollar Index DXY, -0.03% a measure of the greenback against six major rivals, is up 2%, compared with a year ago, having given back some gains this month. A stronger dollar can be viewed as a headwind for export-oriented U.S. companies, making their goods and services more expensive overseas.
But reminders of the February selloff, which saw the S&P 500 SPX, -0.35% and the Dow fall more than 10% from their late-January records and meet the commonly used definition of a market correction, are offset by what Darby and company call the “case for the defense.”
First, they argue that U.S. real interest rates—or rates adjusted for inflation—remain at zero, reflecting little or no tightening to date. Second, there is no sign of a slowdown in robust economic data. And third, while tech and health care stocks have dominated inflows over the past week, they said the performance “is reminiscent of the concentrated momentum, quality rally seen in August,” which took the S&P 500 back to record territory.
Finally, yields across all Treasury maturities would need to climb dramatically for stocks to look expensive in terms of free cash-flow yield, compared against rates for government debt, the analysts said.
The bottom line, the analysts said, is investors would have to see a deterioration in earnings forecasts, better relative growth in emerging markets or a rise in U.S. real rates above 1% to become bearish on the U.S. market.
