The remarkable resilience of equity markets this year, along with the general bullish consensus for 2021, has some parallels with previous price action in 2009 and 2017

In 2009, equity markets rallied against a backdrop of a terrible economy, but rising leading indicators and strong policy stimulus. The rally extended until January 2010, before the S&P experienced an 8% correction in February 2010.

Charts Source: Bloomberg, Macrobond and Variant Perception

In 2017, the S&P rallied through the year with minimal drawdowns, against a backdrop of fiscal stimulus (Trump’s tax cuts) and the Fed, under Janet Yellen, hiking rates very cautiously.

The 2017 rally extended into January 2018, before a -11% correction in February 2018. Given the analysis we presented to clients recently on seasonal equity inflows in January, it seems plausible that today could see a similar pattern, where markets keep grinding higher into January 2021 and we see a correction in February.

Charts Source: Bloomberg, Macrobond and Variant Perception

Although these historical parallels are worth noting, there are a few other signs that this year’s rally is not yet as extreme as the 2009 and 2017 episodes.

Firstly, the chart below shows the rolling T12M Sharpe ratio of the S&P 500. We can see that in the February 2010 and February 2018 corrections, the Sharpe ratio of the S&P surged higher towards 3 before seeing a correction. Today, the Sharpe ratio is still low.

Charts Source: Bloomberg, Macrobond and Variant Perception

Secondly, in February 2010 and February 2018, the Fed balance sheet had already stopped growing on a year-on-year basis. This tempers the bearish correction analogies from 2009 and 2017 somewhat.

Charts Source: Bloomberg, Macrobond and Variant Perception

Another very interesting phenomenon from the this year’s equity-market rally is that implied volatility has remained elevated. Normally, periods of sustained high VIX readings occur during market sell-offs. The chart below shows that when the 1-month average of the VIX is above 25 this normally coincides with sell-offs.

Charts Source: Bloomberg, Macrobond and Variant Perception

The red bars in the next chart show the periods when the VIX is above 25 against the S&P. It is interesting to note that it has only been in 2020 and in 1998/99 when we have seen an extended period of rising equity prices along side high VIX readings.

Charts Source: Bloomberg, Macrobond and Variant Perception

One reason for elevated VIX levels, which we have previously noted, is that with fixed-income yields very close to zero, multi-asset investors can no longer rely on fixed-income allocations as equity hedges, so they are forced to buy equity volatility to hedge equity risks, forcing up implied volatility.

The CBOE index put/call ratio is also extremely high at the moment, showing a high demand for hedging. This could mean that investor positioning is not as complacent or euphoric as pure sentiment surveys would indicate.

On balance, a similar retracement next year to what was seen in early 2010 and 2018 is possible from the price action, but it is not our base case, given today’s underlying strong macro, and strong liquidity growth.