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.
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.
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.
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.
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.
Bottom line: Chalk up the Implied Correlation Index as another warning flag for S&P 500 bulls. Lower correlations generally mean higher risk and weaker expected returns from US large cap stocks. The IC index has fallen back to pre-COVID crash levels as the SPX inches toward new all-time highs.
6. An alternative view of volatility -- kind of puts things in perspective... There have been more than 80 trading days in the last year that have featured moves of 1% or more on the S&P 500. That is the highest tally since the 2011 European Debt crisis period. What’s interesting about the current spike is that the S&P 500 is basically at an all-time high. The prior peaks in 12-month counts of daily changes exceeding +/- 1% usually coincided with downturns in equity markets. What’s unusual about this year is that there was virtually no volatility heading into the February-March COVID-crash, then the equity market recovery was nearly as swift as the rapid fall. Another wrinkle is that the VIX has actually been hesitant to return to the teens – it seems to be finding some support in the low-mid 20s.
Putting that all together – couple very recent volatility with rising stock prices, and we get this very unusual event in which there are daily moves of 1% or more, yet stocks are back near the highs. How long can this keep up? Will one event bring the S&P 500 back down? It’s been several weeks since a very sharp daily decline, but recall what happened in early June – the S&P 500 had a 6% drop in a single day! Events like that can happen in this environment.
What’s interesting is that you can look to late 1987 for a similar occurrence of the 12-month count of daily moves of 1% or more happening alongside a fresh high in stocks. Many have compared October 1987 to March 2020, so maybe this plays into that narrative as well. But (on the bearish side) the late 90s top could be another example of heightened volatility with a rising S&P 500 – a nasty bear market soon followed.
Bottom line: The S&P 500 has had a tumultuous past 6 months. The vast majority of 1% moves over the last 52 weeks have been confined to the February-August timeframe, yet stocks have recovered just about all the losses from the COVID-crash. How long can the bulls keep moving stocks higher in the face of elevated volatility though?
7. That same indicator, but directional volatility... as you might guess, there have been more high volatility up days than high volatility down days so far. Volatility usually begins to creep up before significant equity market declines, then the VIX is slow to recede as stocks recover. What ends up happening is the rolling 12-month count of daily moves of 1% or worse peaks before the count of 1%+ daily gains. In the chart below, the green line usually lags the red line, but the two are often rather close. 2020 is different (of course it is!).
The green line, the rolling 12-month sum of daily moves of +1% or better) has far outpaced the red line. Think back to February and March – a 2% decline seemed like a day that was basically unchanged. There were days that featured limit-down moves at the open, then closes down 8% or worse. So there actually weren’t a high count of days with 1% or worse losses. As the S&P 500 recovered though, there have been many days that are just 1-2% ‘ho-hum’ gains on little news. You have to go back to the mid-late 90s to find a similar stretch of upside-volatility. The mid-late 80s another such period, too. So it’s been a while since we have experienced a market like this. What does it portend?
There are two types of markets where volatility is high and rising: bear markets and erratic/euphoric bull markets. And with regards to that, my sense from all the surveys and anecdotes I see is that opinion is split down the middle between bulls and bears. It's a market that's there for the taking for possibly either camp, and possibly both as the competing forces of a long risk list vs a long stimulus list keep markets both volatile and at least for now propped up.
Bottom line: Rising volatility is typically a bad thing (typically is seen during bear markets, downturns), but there is a rare kind of market where prices grind higher on higher volatility, and with ample stimulus and ample risk, maybe that's what it is now.
8. The "Economic Noise Index". ...some will say it's just noise. Ignore the noise. We all hear it on the Finance-Twittersphere, but we can plot it on a chart, believe it or not. The US Economic Noise Index combines the Economic Surprise Index and the Economic Policy Uncertainty Index (inversely). The former is an index that shows how economic data is progressing relative to consensus forecasts. When economic data points verify better than Wall Street analyst expectations, then the surprise index climbs. The latter index combines three variables: 1) newspaper coverage of policy-related economic uncertainty. 2) tax code provisions set to expire in the coming years. 3) disagreement among economic forecasters.
So the US Economic Noise Index is quite interesting. It usually falls hard during equity bear markets, then oscillates in positive territory during calm times. We can think of it as tracking the levels of positive vs negative economic background noise.
Currently, the Economic Noise Index is about the most positive it has ever been. But I want to draw your attention to the times when the index spiked lower. Early 2003, late 2008, mid-late 2011, and of course it fell off the chart in early 2020. All of these times were crisis-lows in the S&P 500. Now here we are at the top of the Noise Index as stocks are near all-time highs.
Bottom line: It’s not always sage advice to ignore the noise. You want to buy when there’s blood on the streets and when the noise sounds cacophonous and dissonant. The time to perhaps take some profits is when data comes in better than expected while policy uncertainty is low/complacent.
9. Interesting chart: aka maybe why he focuses so much on the stock market... @OntheMoneyUK brings us an S&P 500 performance chart from LPL Research and FactSet. This is one of the best looks at election & seasonality we have seen. If you want a glimpse into who may come out victorious on the evening of November 3, 2020, look no further than the S&P 500.
The middle of August to the middle of September is the time to watch for stock market moves as it pertains to who may win on election day. Before this stretch, stocks tend to drift higher regardless of the eventual winner. But it’s during the middle of Q3 when things begin to get interesting. If the S&P rises from mid-September to election day, there is a better chance that the incumbent party retains the White House. If stocks fall during this timeframe, the incumbent party likely gets booted. We can talk about the chicken vs the egg on this apparent relationship, but it's certainly an interesting pattern to ponder.
But there’s more to the chart. The late January to mid-March period is key as well. It perhaps does not bode well for President Trump given stocks fell sharply all the way back in March (seems like a distant memory now!). A falling S&P 500 during Q1 has often happened alongside an eventual general election defeat for the incumbent party. Naturally there are always exceptions to the rule, and again, maybe it's different this time...
Bottom line: Stock market trends ahead of elections are interesting and even fun to look at, but of course anything can happen. Also consider that 2000 and 2008 certainly moved the ‘average’ charts quite a bit. Nevertheless, the next few weeks could provide clues as to which party wins the Presidential Election.
10. Interesting chart: world market cap vs world GDP. Breakout or Barrier? @TihoBrkan posted this Bloomberg chart of global market cap and GDP. It’s not often that the world’s market cap climbs above GDP, but it has happened again this year. Also consider that global GDP is likely significantly lower than it was marked at on December 31, 2019.
Going back nearly 20 years, this crossover happened in late 2007, early 2018, and early 2020. Each of those times marked a top in the global stock market. Could we be doing it again? Or is it different this time? Low interest rates and other incredible central bank actions have helped bring stocks back near the highs. In many respects 2020 is an unusual year, maybe it is different this time...
Bottom line: It’s a warning sign when market cap exceeds GDP. It hasn’t happened many times before, but each recent occurrence has preceded sharp equity market declines.
So where does all this leave us?
1. Volatility flashing warning signals.
This is the time of year to err on the side of defense (certainly at least review risk management policies and processes). Equity market declines and jumps in volatility are common from mid-August through early October. At the moment, the VIX futures curve is in contango – that means near-term volatility is expected to be lower than volatility in the coming few months. The election could have something to do with that, but it also could be normal seasonality at play. It’s not just the volatility on the S&P 500 either. The Nasdaq’s VIX is forming an apparent bullish (higher implied vol) pattern, which would mean bad things for that equity index and mega cap growth stocks that have led the way the last few years. Meanwhile, the S&P 500 has had more than 80 moves of 1% or more in the last 52-weeks – the bulk of which have come in the most recent 6 months. Still, it’s been volatility due to mainly upside price moves during the last two months.
2. Credit spreads, implied correlations are concerning.
Digging deeper into the volatility theme, US high yield credit spreads have retreated to near normal levels while the S&P 500 VIX remains a bit above its historical average. The Fed’s aggressive actions have helped ease credit markets, and thus tighten spreads. But how long can the Fed support go on? Elsewhere, the Implied Correlation Index has drifted lower as the market eases from crisis levels. Maybe it’s a stock-picker’s market once again. But investors should beware – when the correlation index drops, complacency could be at our doorstep.
3. Noise & the election.
US economic data has surprised to the good side in the last few months. Corporate earnings beat analyst expectations, too. Still, heightened economic policy uncertainty remains. The result is a very high Economic Noise Index. The index tends to be correlated to the stock market – investors want to be buyers when the noise is negative and cautious when it is high. Meanwhile, another clue could be found in the seasonality of the S&P 500 during an election year. The upcoming stretch is a critical one in determining which party wins the White House. Finally, the market is also on edge regarding the recent crossover of global market cap to GDP. So there are a lot of reasons to be uneasy if you are an equity market bull. How long can the wall of worry be climbed?
The S&P 500 has come full circle since the peak in February. A 35% drop has been recovered – the index nearly made a fresh all-time closing high last week. Tack on dividends, and the total return index is positive from the February 19 peak settle. There are significant red flags for investors though. Seasonality favors the bears right now and volatility tends to be on the increase during the back-half of Q3. Toss in heightened election (and geopolitical) risk, and there may be rocky times ahead versus the calm and climbing stock market we have seen during the last two months. Looking longer-term, US large cap stocks are richly valued versus history – and that has helped drive-up global market cap to GDP. Investors should be mindful of the sectors/regions that have been left behind, as rotation is a key theme on our minds.
See also: Weekly S&P500 #ChartStorm - 9 Aug 2020
Thanks to Mike Zaccardi, CFA, CMT, for his help in putting this together.
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