Market Volatility Playbook

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Market Volatility Playbook

Even if Friday’s equity market selloff (S&P 500 -2.3 percent) came on a light volume day due to the US Thanksgiving holiday, it is still a +2 standard deviation move for the index. As such, it’s worth taking a few minutes to consider 1) what it may mean for future stock market returns and 2) how to trade or invest in what may be a more volatile investment environment going into year end.

Four points to consider:

#1: Before Friday, the S&P 500 had only shown one-day losses of 2 percent or greater on 4 days since November 2020 (i.e., when the first vaccines were announced). Here is how the index performed on those dates as well as the following day:

  • January 27th, 2021: -2.6 percent
  • January 28th: +1.0 pct
  • February 25th, 2021: -2.4 percent
  • February 26th: -0.5 pct
  • May 12th, 2021: -2.1 percent
  • May 13th: +1.2 pct
  • September 28th, 2021: -2.0 percent
  • September 29th: +0.2 pct
  • Average day-after returns following a +2 percent selloff day: +0.5 percent

This is quite different from the market action at the start of the pandemic in March 2020:

  • February 24th, 2020 was the first real selloff day last year, with the S&P 500 down 3.4 percent.
  • The next day (the 25th) was almost as bad: -3.0 percent.
  • The two days after saw no bounce at all: -0.4 percent (the 26th) and -4.4 percent (the 27th).
  • The S&P would not bottom for another 17 days (March 23rd), 22 percent lower than the February 27th close.

Takeaway: Monday should see US stocks recover at least some of their Friday losses. This is what’s happened, on average, for over a year and will signal investor confidence that the new pandemic variant is not an existential threat to the ongoing global economic recovery. Now, if we do get another +2 percent down day on Monday, that will begin to spook markets. Traders and algorithms know the math we’ve just shown you. Bottom line: Monday needs to be a good day for US/global equities.

#2: News of the latest pandemic variant may have spooked equities on Friday, but Fed Funds Futures markets don’t think whatever comes of it will change central bank rate policy next year. Here is the CME FedWatch chart showing the probabilities for various rate scenarios in December 2022.

As you can see, the probabilities here have scarcely shifted. The modal (highest) odds are for 2 rate increases next year, at 31 percent. Three hikes aren’t unthinkable (26 pct odds) and have a higher likelihood than just 1 rate increase (20 pct).

Takeaway: if the new pandemic variant is set to cause a US/global recession, it’s news to the Fed Funds Futures market, which assumes the Federal Reserve will keep its upbeat messaging about the US economy at its December’s meeting. Yes, one could ask “might current pricing just reflect a Federal Reserve that must fight inflation in 2022 at all costs, even at the risk of exacerbating economic conditions?” Our answer is “No”; just look at the central bank’s focus on labor market conditions over the last 20 months, even as inflation has remained stubbornly high.

#3: Retail investors have become an important part of the US equity market ecosystem, and Friday’s selloff saw them buying aggressively. Data here for the top 10 most-traded names on Fidelity’s retail platform:

  • Better to buy: Apple (3.5x more “Buy” than “Sell” orders), Tesla, (2.3x), NVIDIA (3.9x ), Boeing (7.7x ), SPY (5.4x ), levered QQQs (TQQQ, 2.9x ), and Microsoft (3.9x),
  • Better to sell/neutral order balance (note: all names here were up on Friday, by 21 – 72 percent): Moderna (1.7x more “Sells” than “Buys), ISpecimen (even), Biofrontera (even).

Takeaway: it is notable that retail was not just buying the usual Big Tech suspects but also index-related products as well – we see that as bullish. Also, the next 10 names on the Fidelity most-traded list look much like the ones we’ve highlighted. US retail was buying Vanguard’s S&P 500 product (VOO), the QQQs, travel names (Disney, Carnival, Delta, American), EV stocks (Rivian, Lucid), and meme stocks like AMC.

#4: If US equity markets continue to sell off, the CBOE VIX Index is a good way to know when any panic hits a crescendo and there might be a good trading opportunity from those levels. The numbers to watch:

  • Friday’s VIX close of 28.6 is almost spot-on the 27.5 level that is 1 standard deviation (8.0) from the index’s long run mean (19.5, back to 1990).

    Worth noting: the last time the VIX was at similar levels (late February, early March 2021), the S&P 500 was trading back and forth around 3,800. It rallied immediately thereafter and has not seen that level since.
  • The next VIX level to watch is 35.5 (2 standard deviations from the long run mean).

    Worth noting: the VIX closed just through this level (37.2) on January 27th, 2021, and that was its YTD high. The YTD low for the S&P 500 came 2 days later (January 29th), at 3,714.
  • The other VIX levels to watch are 43.5 (3 standard deviations), 51.5x (4 standard deviations), and 59.5 (5 standard deviations).

    The only times we’ve seen these levels or higher were in 1998 (peak 45.7), 2002 (peak 45.1), 2008 – 2009 (peak 80.9), 2001 (peak 48.0), 2011 (peak 48), and 2020 (peak 82.7).

Takeaway: just because we’re at 1 standard deviation (28.6 VIX) doesn’t mean we can’t go to 36 or even 44 in a market meltdown, and once that process starts it’s important to have a playbook for where to add equity exposure and/or risk. VIX levels are never perfect indicators of a bottom, but we do find them a useful reference point when markets become volatile.