Investors are on edge ahead of event risk

Thus far the summer of 2016 has been highly volatile, and we don't see any signs of this changing anytime soon. From grains, to energies, to currencies and, of course, the financials, there have been fortunes made and lost in the markets. We suspect this trend will continue well into the fall months. Accordingly, it is generally a good idea to try to keep speculative bets on the small side.

Risk-off assets such as Treasuries and gold are highly overextended despite the fact that equity market are hovering at relatively lofty levels. In our view, this offers a glimpse into the minds of investors; it is clear they are far from comfortable with the current environment. We can't blame them; we've yet to resolve the Brexit vote implications and we will soon be forced to endure the latest US employment report and, more important, it's potential impact on the Fed's interest rate policy. Soon after, the second quarter earnings season will roll out. With all of this in mind, it might be worth unloading some risk where possible.

A healthy jobs report, a potential Dodd-Frank peel back, and renewed talks of tax cuts propelled markets higher.

Financial futures traders loved Friday's events and they expressed that sentiment by buying into US assets. For the first time in a LONG time, the jobs report was judged by its merit as opposed to the anticipated reaction by the Federal Reserve. In other words, the markets no longer seem to be held hostage by the Fed's every move. Instead, investors are looking to speculative economic growth as the driving factor with the Fed's monetary policy as a secondary concern.

Non-farm payrolls grew by 227,000 in January but the good news was slightly dampened by sluggish wage growth. On a positive note, the unemployment rate ticked higher to 4.8%. No, that isn't a typo...a higher unemployment rate is a positive. The increase in the unemployment rate is a sign that the labor force has increased. In short, some of those who were discouraged from looking for work have found a reason to get back on the job-hunt (remember, the headline unemployment report fails to recognize those who stopped looking for a job out of frustration but are still unemployed).

The Fed is as hawkish as they've been in years...

A hotter than expected inflation reading and more confirmation from the Fed that they will be seeking at least three rate hikes this year set a negative tone for Treasuries. However, the same news was seen by stock trader as a sign of economic growth and prosperity. Accordingly, the seemingly never-ending stock market rally logged another session of buying. What can we say? This is a bull market...and nothing can derail it. In recent weeks we've seen chaos in Washington, riots in the streets of our cities, a North Korean missile headed for our shores, but we've yet to see investors interested in taking profits in the equity markets.

If you ask me, the bulls are starting to get greedy (that said, we've obviously been wrong about the strength of this rally). According to our friends at Consensus, their bullish sentiment index has reached 76%. Generally speaking, this signifies an extreme that often results in a reversal. Likewise, The AAII Index suggests only 25% of those polled were bearish the market. The bus could be getting full...and we all know that that means.

It is early, but October has been the least volatile month...EVER.

If today was the end of the month, this would be the quietest October on record and it would also be the quietest month ever. Of course, it is too early to suggest that is what is in store for the markets come October 31st, but it should at least offer some perspective.

Further, it has been almost a year without a 3% drawdown in the S&P 500. This is the second longest run of its kind in history. If the market survives the next 10 days, it will beat the previous record. Keep in mind, 3% is literally a drop in the bucket. At today's price, that would be a mere 75 ES points.

We don't when the dam will break, but we do know it always does, eventually. Traders should be on their toes. Afterall, investor complacency is at an all-time high and historically such environments haven't ended well.

As mentioned in a previous newsletter, the University of Michigan stock market sentiment index measuring the percentage of investors that believe the stock market will be higher a year from now is at an all-time high. Similarly, credit spreads are near historical lows (this is the difference between the yield on high-risk securities and risk-free Treasury securities). Tight credit spreads suggest investors are reaching for yield and lack concern for economic turmoil (in short, they are complacent). The last time we saw such tight credit spreads was mid-2007, just prior to the financial collapse. We aren't predicting a repeat of 2007, we are simply saying the bulls should consider exercising caution. Is anybody familiar with "Old Man Partridge" from "Reminiscences of a Stock Operator"? The trend is only your friend until it ends.

Trade tariff talk is just that, we've yet to get anything concrete. Yet, the market is emotional.

This is nothing new, if there is anything we've learned from the first year (+) of the Trump presidency it is the conversation always starts with drama, but then settles down to something more reasonable. Unfortunately, the markets haven't quite figured that out yet. Those that believe markets are efficient, will have a hard time explaining what we've seen in the previous three or four trading sessions.

Tariff discussions, without any concrete decisions, can't explain such big swings in asset prices. The only rational explanation for this type of volatility is (ironically) irrationality. Markets are emotional, and we are being reminded of that. The low volatility slumber of 2016 and 2017 were anomalies and are probably behind us.

The "buy and holders" might not be happy with the market environment before us, but the reality is the expanded volatility will eventually provide opportunities for traders (particularly option sellers). Further, it might not feel like it but this is a healthier market than what we saw in late 2017 and January 2018.