A Hobbesian correction?

So now that the dust has settled (if only for the time being), what are we to make of it all?  Is there another sting in the tail for equities, or was this merely a Hobbesian correction (e.g., nasty, brutish, and short)?

We may find out soon enough.  A few short days after the market was in abject panic, and we're already at the tell-tale 1900-1905 region on Spooz.  As a refresher, this is not only the region of the 200 day moving average (a break of which saw the downtrade accelerate), but also a level that has prompted a reaction on previous visits as well.

Gun to the head, Macro Man would take the side of the market resolving higher over the next month or so.   While it's true that VIX has already fallen very sharply since it touched 30 (an "old school" turning point level, as Macro Man opined in one of his rare Twitter forays last week), over the past couple of years gap reversals from a VIX high have tended to hold and extend.  And this was quite a gap reversal.....

One might also credibly project that buybacks will accelerate after this earnings season and into the end of the year.   Not only is Q4 a seasonally strong time for buyback activity, but many companies might find their stock prices "on sale" given the recent volatility, an added incentive to engage in that sort of activity.

Ultimately, Macro Man's equity market "conscience" resides with a model that he has run with some success since before the crisis.  This simple model, which he has occasionally referenced over the past 8 years, is a simple projection of 12 month forward SPX returns.   Although the forecast is not to be taken as gospel, he has found that both the shape of the line and the magnitude of the forecast relative to volatility to be useful guides for future performance.

In this case, the 12 month projection is still well above the historical norm, and has even improved slightly after a small hiccup over the summer.  As long as the model is this bullish, Macro Man struggles to adopt a secularly bearish stance.

That having been said, there are further insights to be gleaned than simply looking at the 12m projection.   As noted periodically in this space over the last several months, volatility should be higher in the future than it was in the pre-October recent past, and the last few weeks' juddering is actually a normalization of the volatility profile.  That ex ante reduces the projected Sharpe ratio of holding equities moving forwards.

Moreover, it seems quite clear that abundant liquidity is a (the?) primary driver of expected equity returns.  No, not market liquidity, which the past couple of weeks have shown is not abundant at all (again, not a great shock.)   Rather, it's financial liquidity, courtesy of ZIRP-world, QE, and the reluctance of any central bank to rock the boat.

Macro Man can disaggregate the forecast above into what he terms 'liquidity' and 'growth' vectors.  Plotting a Z-score of these factors relative to the historical norms, we see that the vast, vast majority of the large expected returns are a function of financial liquidity factors. 

It's interesting to note both the astounding degree to which liquidity factors have driven expected equity performance, and also that they seems to have tailed off recently.  Should this trend continue, then it would be up to growth factors to pick up the slack or else see the forecast return decline- perhaps sharply.  When that happens, of course, Macro Man reserves the right to change his mind and raid his closet for his bear suit.

Until then, he plans on continuing to tread warily, adding risk selectively when market have a tantrum, and cutting back on risk when the SPX looks like the festival of San Fermin.