Weekly S&P 500 #ChartStorm - 16 Aug 2020

Those that follow my personal account on Twitter will be familiar with my weekly S&P 500 #ChartStorm in which I pick out 10 charts on the S&P 500 to tweet. Typically I'll pick a couple of themes to explore with the charts, but sometimes it's just a selection of charts that will add to your perspective and help inform your own view - whether its bearish, bullish, or something else!

The purpose of this note is to add some extra context and color. It's worth noting that the aim of the #ChartStorm isn't necessarily to arrive at a certain view but to highlight charts and themes worth paying attention to. But inevitably if you keep an eye on the charts they tend to help tell the story, as you will see below.

So here's another S&P 500 #ChartStorm write-up!!

1. VIX futures curve indicator looking overbought. Most traders and even long-term investors know about the VIX – the S&P 500 Volatility Index. Spot VIX measures the stock market’s annualized volatility over the next 30 days using S&P 500 options. A normal reading is near 18-20 – the VIX was in the teens before the COVID crash then erupted above 80 during the peak of the crisis in March.

Market-watchers like to go more in-depth though. One market indicator is the nature of the VIX forward curve – “the term structure”, we call it. Right now, the VIX futures curve is in contango – that means the prompt-month futures contract is far below outgoing months. Spot VIX settled just above 22 on Friday, but contracts later this year and in early 2021 are near 30. What does this mean? It could portend that volatility is in the offing, while the near-term market might be calm. It’s not surprising with the election less than 3 months away.

But take a look at history on the chart below. Whenever the ratio of longer-term VIX contracts to the near-term contract is high, stocks are closer to overbought than oversold. At the two market bottoms since 2018, the VIX curve was sharply backwardated.

Bottom line: Contango on the VIX futures curve is a warning sign for the bulls. Volatility could be on the horizon while the S&P 500 has been charging toward the February all-time highs. VIX futures have not been at this much of a premium to spot VIX since late 2017 when the market was extremely calm.

chart of S&P500 vs VIX future curve indicator

2. The VIX of the Nasdaq, VXN, "has formed a *massive* 3-month base" -- higher volatility to come? Thanks to the excellent @MacroCharts for this view of the Nasdaq Volatility Index displaying a potentially bullish pattern. The VXN has featured a basing pattern in the last several months – similar to what occurred near prior tops in the tech-heavy index. The recent 3-month base, supported by the 200-day moving average and 2019 highs, could be a launching zone for volatility in the final few months of the year.

Bulls really want to see volatility breakdown to the 2017-2019 low area, but there is currently ample support for Nasdaq volatility. Based on the technical feature, a potential volatility target in the mid-50s could be in play, per MacroCharts. Expect a sharp correction in the Nasdaq Composite and on the Nasdaq 100 ETF (QQQ) should that technical move happen.

Bottom line: FAAMG has been a market leader this year – if volatility breaks out on the broad Nasdaq Composite and withing the Nasdaq 100, then expect mega cap growth stocks to get hammered.

chart of nasdaq vix

3. As for the original VIX - it's been trying to chase down junk bond spreads (a nice little side effect of the Fed buying corporate bonds and credit ETFs). The S&P 500 VIX and the US high yield credit index option-adjusted spread typically track quite closely for a few good reasons. This year has been a little different considering the Fed pulled out all the stops to support bond markets. Back in 2008-2009, the VIX spiked to about 80 and junk credit spreads had a commensurate blowout above 20% - or 2,000 basis points.

This year, however, the VIX once again reached 80, but the HY OAS index only climbed to near 12% at the peak. Right now, volatility remains somewhat elevated versus history while high yield spreads are within the range of the past several years. The question for traders is, “which one catches up to the other?” Will the S&P 500 volatility index fall back down to the long-term average of 18-20 (or below) as we head into year-end, or will high yield spreads shoot back up?

If the stock market remains somewhat quiet, the credit and volatility markets could provide significant clues to the next equity market move. So be on watch. If we do see an upward move in HY credit spreads, keep an eye on the 900 basis point area – that is where spreads climbed toward during the 2011 European Debt Crisis and during the early 2016 height of the Commodity Collapse.

Bottom line: Portfolio managers use credit and volatility markets to gauge risk appetite in financial markets – particularly when there isn’t much to be gleaned from equity markets. There are fascinating moves taking shape in volatility and credit spaces.

chart of the VIX and credit spreads

4. It could be different this time, but the seasonal tendency is for credit spreads to widen and the VIX to head higher around this time of the year. It’s that time of year for volatility and overall risk rear its ugly head. August through early October is notorious for being when market corrections take place before year-end rallies among risky assets. Seasonality has been a lousy indicator thus far in 2020 (as it turns out, it has been different this time!) – with equity markets tanking during what is normally a good time of year, Q1 and early Q2. Then stocks climbed, volatility dropped, and high yield spreads collapsed during the springtime and summer.

But perhaps seasonality comes back into typical fashion this fall. On average, the VIX has increased from the upper teens in the summer to the low-mid 20s in early Q4. At the same time, junk credit spreads widen during the latter half of the year. Backing out the wild swings of 2008-2009, high yield spreads peak right at the turn of Q3 to Q4. Anything can happen of course, and seasonality is a secondary indicator to what is happening price-wise, but these are important considerations from a risk management perspective as we head into the next several weeks.

Bottom line: August and September are historically troubled times for risky assets. We all know that stocks tend to go through sharp corrections this time of year, but we also see it play out in the volatility index and in high yield credit spreads from July-August into September-October.

chart of credit spread and VIX seasonality

5. The second cousin of the VIX, the Implied Correlation Index has moved back towards pre-crash levels. As a contrarian indicator risk is elevated when correlations fall like this

They say that correlations go to 1 during a crisis. There is some truth to that as the Implied Correlation Index tends to increase sharply when the VIX soars, then as markets normalize and volatility ticks lower, implied correlations ease. That’s when we hear the folks on the financial news networks proclaim, “it’s a stock-picker’s market again!”.

It’s getting to be about that time... The Implied Correlation Index, which spiked to about 70 earlier this year, is entering the range from the relatively calm times of 2017 to early 2020 between 30 and 50. This is another warning flag for investors that complacency could be setting in at the wrong time. The Implied Correlation Index is a contrarian indicator – you want to buy stocks when the index spikes (typically when virtually all risky assets are selling off in unison), whereas when correlations drop and for instance maybe one small sector of the market is driving prices, then you want to focus on risk management.