Catching up with reality

Markets have had an exhilarating run up over recent weeks.  Since the start of the month the S&P 500 has risen by close to 7%,gaining around 58% from its March low, as the evidence of global economic turnaround has strengthened and the outlook for earnings improved.

Nonetheless, the rally in equities has meant that valuations are starting to look stretched again. For instance the price / earnings ratio on the S&P 500 has risen to its highest level since January 2004, perhaps hinting at the need for a degree of investor caution in the days and weeks ahead.

Other factors aside from the pace of the move also call for some restraint to market optimism such as the potential for escalation in trade tensions between the US and China, the imposition of regulations on banks and the timing of reversal of extreme stimulus measures. 

As the panic has left markets over recent months volatility has eased as reflected in the VIX index which has dropped to around its lowest level since September 2008, just before it spiked massively higher in a matter of weeks in the wake of the Lehman’s blow up. 

This has been almost perfectly echoed in the move in currency volatility, which has dropped to around the levels last seen a year ago for major currencies.  These levels are not quite pre-crisis levels but for the most part pre-date the collapse of Lehman Brothers, reversing almost all the spike in risk aversion that took place from a year ago. 

It is probably not too much of a stretch to state that having expunged the shock of Lehmans and the worst fears about the global economy from measures of risk and volatility the room for further improvements may be somewhat more limited.  This may be countered by the fact that economic data continues to deliver positive surprises relative to consensus, providing fuel for a further rally in risk appetite. 

However, a lot of good news must surely be in the price by now and it is likely that even the most bearish of forecasters has to acknowledge that an upswing in activity is underway. This ought to ensure that consensus forecasts catch up with reality, leaving less room for positive surprises and perversely less support for equity markets. 

The rally in risk appetite and equity markets has taken its toll on the US dollar which has had a gruelling few weeks during which the US dollar index (a basket of currencies versus USD including EUR, JPY, GBP, CAD, SEK and CHF) has hit new lows almost on daily basis.  Any pause in dollar selling driven by a softer tone to equities is likely to provide better opportunities for investors to take short positions in the currency given that little else has changed in terms of USD sentiment.   How far can the dollar drop?  Well for a start the April 2008 low around 71.329 for the USD index beckons and after that its into uncharted territory.


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