Stocks Like Higher Yields And Lower Volatility

Stocks fell sharply on inflation concerns in early February, but the speed of the 10% correction and impressive 2,000 point bounce back have left investor psychology and their risk exposure unfazed. Bull markets love to climb a wall of worry and bears slide down a hole of hope. Typically investors are scared to the sidelines, selling the decline prior to a new major leg higher in stocks. The current rally is impressive, but buyers should beware until volatility and yields fall back lower once again.

While the short term shock of strong economic reports sent interest rates higher and stock indices lower on inflation fears, we have pointed out before that the majority of bull markets witness stocks and yields rising in sync, until rates choke off credit.Yields and stocks diverged briefly in early February on the wage inflation report. Since that 12% correction low last week, the Dow has risen almost 2,000 points in six straight up days. Now that stock indices have retraced 65 to 80% of their declines and have tested the 20 day moving average of resistance, it would be normal for the recent rally to stall.

Along with yields, investors should be cognizant of volatility (VXX). When these larger equity price declines occur, volatility measures moves from complacency to high anxiety. What we find in common with most pullbacks of 10% or more is that when volatility spikes during the initial fall in stock prices, we need about a 50 to 70% retracement of the level of volatility. At that point there is a higher confidence level that the correction is ending and the bull market in stocks may be ready to resume.

Stock indices finally had the long awaited 10%+ correction so many thought would be healthy for the longevity of this Bull market. However, prices fell so suddenly that investor psychology became mildly negative for only a few days and heavy investor equity holdings haven’t had time to be instilled with sufficient fear to generate any liquidation and sideline cash. We would certainly respect the power of a move back to record high stock prices and low volatility readings, but we remain skeptical that sustained moves to record highs have staying power until fear levels become more persistent. Let’s be patient as earnings season terminates in late February. We remain longer term bullish as this economic expansion enters its third year since the 2016 energy recession nadir, but with suddenly higher interest rates, stocks need time to grow into their elevated valuations.