Sometimes the easier path to solving a complex problem is to analyze a parallel question instead. A prosaic example: when considering the purchase of a car or other expensive item I will often make a list of all the choices I would NEVER consider along with an explanation as to why. That exercise always leads me to delete several items on my consideration list because they actually include those same undesirable qualities.
In that spirit, let’s forget about where the S&P 500 goes in the back half of Q2 2020 and focus instead on forecasting the CBOE VIX Index level on June 30. We’ll start with what we know for sure:
- The VIX trades for 31 right now, which is still more than one standard deviation (8.1) from its long run average (19.3). Today’s afternoon reversal for US stocks is a good reminder that volatility remains elevated well beyond normal.
- The VIX hit an all-time high of 83 on March 16th. Since then, US fiscal and monetary policy have aggressively and speedily responded to the initial economic effects of the COVID Crisis.
- Fed programs are now effectively backstopping many forms of corporate and municipal debt, and capital markets are functioning more normally (albeit with higher spreads than pre-COVID).
- All this has calmed markets and allowed them to rally in the face of weak Q1 corporate earnings, a lack of earnings guidance for the rest of the year, and downright awful economic data. The VIX has dropped as the move higher has continued.
So, what do we have going on for the next 6 weeks (29 trading sessions) that could inform the direction of the VIX? We see the following balancing acts as driving near term market volatility:
- Continued awful labor market data versus…
supplemental unemployment insurance payments that make many workers whole for lost earnings. This buffer has a short fuse, however, and without further Congressional action will burn out at the end of July.
- The traditional end-of-quarter earnings prerelease season at the end of June versus…
fewer companies providing guidance that might require a traditional warning to markets.
- The news that many US states are beginning to reopen in earnest versus…
fears of a flare up in COVID cases that might begin to overwhelm local health care systems and cause regional curtailments in economic activity.
- Global governments focused on reopening their economies versus…
growing geopolitical tensions between western countries and China (the US is not alone on this issue).
The VIX, in its role as measure of near-term S&P 500 price uncertainty will respond to the aggregate weight of these issues and 30 years of historical data show its near term direction will reliably predict if US stocks are higher or lower when Q2 ends. Three points which underpins that statement:
#1: The long run correlation between daily changes in VIX and S&P 500 prices is -0.75 on both rolling 30- and 90-day measurement periods back to 1990 and we are close to those levels right now (-0.71 over the last 30 days, -0.73 over the last 90 days).
#2: The 30-day chart below shows the VIX/S&P correlation has been consistently negative since the late 1990s; it was briefly positive for a few periods from 1990 – 1992 but never since. Moreover, if you just look at the 2010 – present timeframe, the correlation between the VIX and the S&P 500 is -0.82 for both 30- and 90-days.
#3: It does not matter much if the VIX is a 50 and goes to 40 or 20 and goes to 15 over 30 or 90 days; the correlations are always and everywhere negative to concurrent moves in the S&P 500.
Our take is all those seesawing pros and cons we listed above both matter and have little chance of substantially resolving themselves before the end of Q2. To us, that signals no change in the VIX between now and then and therefore little-to-no change in the S&P 500. The one place where we could be surprised to the upside is in the speed of economic restarts. Our TomTom traffic monitors do not yet show that happening, however. In terms of downside moves, we worry that jobs / earnings / reopenings / geopolitics could mostly or all tip just slightly negative versus current consensus.
Bottom line: it is easy to see how a VIX at 28-30 could be the new normal for a while and history clearly says US stocks will not move noticeably higher or lower during that time. We remain optimistic on US large caps but also understand that further rallies need robust answers to some difficult questions.