In a post on Marketwatch.com, 2015 NAAIM Wagner Award winner Michael Gayed discusses the odds of a summer correction.
“Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.” – George Soros
We just saw one of the most incredible rallies in recent history over the last few days, as the VIX index had its worst five-day percentage decline in history. Greece’s can has been kicked yet again, and we are back in the very familiar “vicious V” formation which has only benefited buy-and-hold investors as opposed to tactical asset allocators and risk managers — a pattern that has persisted since the small-sample period of 2013 began.
I maintain that the odds favor a summer correction and that the declines are far from over. Notice I say the “odds” here — I am not making a call on stocks, as a call assumes with 100% certainty that something is going to happen. Investing/trading is and forever will be a game of probabilities.
So let us for a moment take an objective look at the odds that favor a period of heightened volatility and stock-market declines ahead in the S&P 500 through the lens of the three award winning papers I co-authored on volatility, risk management, and conditions that favor a stock market breakdown. Two of those papers I have presented to thousands of financial advisors over the last year.
Lumber and gold
In our 2015 NAAIM Wagner Award winning paper, Charlie Bilello and I document the predictive power of lumber and gold as it relates to stocks and bonds (which we will be discussing in a webinar on Tuesday). The finding? When lumber outperforms gold, risk-on tends to be the right position for cyclical stocks. When gold outperforms lumber, risk-off dominates as Treasurys benefit from the coming stock-market volatility the relationship suggests is likely.
Why? Because gold is a safe-haven asset, while lumber is cyclical due to its ties to housing and construction. In that paper, we documented 13 weeks as the timeframe to evaluate the ratio. Take a look at the price ratio of lumber to the SPDR Gold Trust ETF GLD, -2.06% Below it is the ratio’s 13-week rate of change. While still positive, the rate of change seems to be at a peak, and the ratio itself looks ready to turn lower, suggesting that in the coming weeks lumber relative to gold may soon signal a tougher environment for equities.