How can we tell when US large cap stocks have hit near term highs and lows?
Whether you are a trader or investor, this has been a critical issue all year. Equity market volatility has been very high, making it difficult to know when to lighten up or add to portfolio positions. Getting these calls right has been one key to outperforming the broader market.
We use the CBOE VIX Index as one tool to assess when stocks become overbought or oversold in the near term. There are 3 advantages to this approach:
- The direction of the VIX is negatively correlated to stock price movements. When it rises equities tend to fall, and the opposite is equally true.
- The VIX has a long history (+30 years), allowing us to analyze its behavior across market cycles. For example, the long run average reading for the VIX is 20 and the standard deviation around that mean is 8 points. Every time we cross a statistically important threshold – 28, 36, 44 and 52 – you know the VIX is signaling ever-higher levels of market stress.
- Tracking the VIX costs nothing and, since it is publicly available, there are no compliance concerns with incorporating it into your investment process.
The chart below shows the S&P 500 over the last year (ending July 29th 2022) and notes the VIX close at every important turning point for US large caps. The dotted line separates the 2021/2022 data.
We see 3 important points in this data:
#1: There is a dramatic difference between the S&P/VIX relationship in 2021 versus almost all of 2022:
- In 2021/very early 2022, near term S&P highs came with a VIX at 16 – 17 (September 2, November 8, January 3). Equity market lows occurred with VIX readings of 23 – 31 (September 20, October 4, December 4).
- Past early January 2022, near term S&P highs came with VIX readings of 19 – 25 (March 29, June 2). The lows for stocks line up with the VIX at 32 – 37 (March 7 and 14, May 9 and 19, June 16).
#2: There is a fundamental reason for that difference. In 2021, markets were not worried that Federal Reserve monetary policy would cause a recession. Once inflation took hold and Fed policy shifted to combat it, that narrative changed. Dramatically, as the VIX clearly shows.
#3: The July 29th VIX reading of 21 says markets are edging towards a belief that monetary policy uncertainty is largely in the rear-view mirror. Recall that the long-run average VIX reading is 20. We are therefore now very close to “typical” expected volatility even though questions remain about everything from inflation to Fed policy, Russia-Ukraine, and the future path of corporate earnings.
The bottom line here is that every investor and trader has an important decision to make right now:
- Either we are sufficiently far along in the Fed’s current tightening cycle/inflation fight that monetary policy will become more predictable and the US economy is strong enough to avoid a sharp recession …
- … Or inflation will remain problematic and Fed policy will need to shift into a higher gear to address it. In that case, a deeper recession is more likely as well as a sharper decline in corporate earnings.
Reasonable people can differ on this question, but we are in the first (more bullish) camp. The US economy is clearly slowing, and inflation should subside. The future band for the VIX should be from 20 to 28, or from the long run average to one standard deviation above the mean. Those are the levels where we think markets will see near term highs and lows over the remainder of the year, spots where it would be wise to add to or lighten up on stock exposure.