DEUTSCHE BANK: Stock Market Confidence Is A Bit Too High, And We Don't Know What's Going To Happen Next

With the stock market just below its all-time closing high, investors and traders want to know what’s next.

Deutsche Bank’s David Bianco thinks the S&P 500 is likely to slip to 1,675 by the end of this year before surging to 1,850 by the end of 2014.

But in the near term, he’s “uncertain.”

In his weekly note, Bianco offers his opinion on the “Next 5%+ S&P price move.” Usually it’s Up or Down.

Here’s Bianco this week:

Recent macro reports give bulls cover for August, but raise stakes for Sept-Oct.

Lack of EPS growth at S&P 500 non-financials in 2Q and over the past 2 years has been relegated to history as recent macro reports point to 2H acceleration. If these reports accurately presage global acceleration, especially in China, US investment spending and exports, then it presents upside risk to our 2013E and 2014E S&P EPS and price targets. While we consider these early signs of acceleration less than definitive, particularly given remaining uncertainty related to the interaction of FX and commodity prices with tapering and rising yields, we switch our Next 5%+ S&P price move to Uncertain from Down.

This is not the first time Bianco has made his “Uncertain” call. But it’s rare.

Among other things, Bianco is concerned that complacency is a bit high in the markets. His preferred measure of this is the PE / VIX ratio. (PE is short for price-earnings, a measure of stock market value. The VIX is the CBOE volatility index, a measure of “fear” in the stock market.)

Here’s Bianco:

The PE / VIX ratio: Market appears confident that it knows the future

Valuations and confidence go hand-in-hand. Lots of cheap with lots of certainty is rare. Thus, markets most easily attract investors when not too cheap with uncertainty only a bit elevated. We think confidence as indicated by the options market seems a bit too high. A higher PE on justifiably higher growth expectations would be preferable to us than any further climb in the PE from investors simply being more confident in prevailing growth expectations.

We use the ratio of S&P 500 PE to quarterly average VIX as a gauge of market emotion. The ratio is currently 1.17 with S&P 500 trailing PE of 15.9 and QTD avg. VIX of 13.7. We are still in “realistic and disciplined” territory, but on the verge of reaching “complacency.” The PE is normal but the VIX is lower than normal. If the PE/VIX ratio materially exceeds 1.2 it will enter the complacency range. This complacency signal may pertain more to the derivatives market than the equity market, more akin to the situation in 2007 than 1999. We think the market is still likely to climb over time, but probably in a more volatile fashion with a higher avg. VIX. In other words, a higher VIX would allow some further trailing PE expansion (on higher albeit less certain expected 2014 EPS) without the PE/VIX ratio exceeding 1.2 and signaling complacency.

As you can see, Bianco’s PE/VIX ratio peaked before some of the most memorable stock market sell-offs in history.

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