Evaluating the Summer Rally

Weekly Update – August 27, 2012

After another slow trading week, markets closed slightly down, with the S&P losing 0.50%, the Dow dropping 0.88%, and the Nasdaq losing 0.22%.[i] With the S&P 500 edging close to another record high, you might be wondering how much higher markets can go in this ‘sugar high’ rally. We’ve been asking this question too, and while we typically dislike getting too much into technical analysis, we want to discuss a technical indicator that could shed some light on the answer.


When determining whether equities are approaching a peak or floor, many analysts turn to the Chicago Board Options Exchange Market Volatility Index (VIX), a measure of the volatility of S&P 500. Historically, the VIX has been an uncanny forecaster of market tops and bottoms; whenever volatility (as measured by the VIX) is low, the S&P has reached a decisive peak, and then fallen. Last week, the VIX hit a multi-year low of 13.45 (anything under 20 is considered low), and we believe that given the lack of economic support for further gains, equities could be poised for a pullback.[ii] Cutbacks in business spending, pressure on food prices, and a weak manufacturing sector mean that the domestic recovery is anything but guaranteed. Weak numbers from China and Europe indicate that our trading partners will be dealing with their own economic troubles for months or years to come. This leads us to believe that the summer rally is fundamentally driven by trader expectations around further global quantitative easing. Recent jawboning by Fed officials, European leaders, and EU central bankers is largely to blame for the recent rally.


So if there is a pullback, what could it mean? How much equities retreat and when they do so will depend on a number of factors, such as the murky global economic outlook, September Federal Reserve meeting, and upcoming elections. In terms of headwinds, we can expect the continued contraction of the European markets to present further challenges, as will a potential hard landing in China. On the flip side, investors could see a boost after the next FOMC meeting, as it looks increasingly likely that the Fed will undertake further quantitative easing. Much will also depend on what action legislators take to address the fiscal cliff. Although it is reasonable to expect an end to our summer market romance, we believe there will be many opportunities for growth further down the road.


To wrap it all up, please remember that short-term gyrations in the market are expected and usually have had little relevance to long-term investment performance. When markets pull back, it can sometimes feel like riding an elevator to the basement, but market losses are rarely evenly dispersed across all sectors. In every market environment there are investment opportunities to be had, and we strive to find those opportunities and putting them to work in our clients’ portfolios.


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