How Much Fear Is Enough?

How much fear does it take to make a bottom in any financial asset? Our answer is that it comes down to context.

• At one end of the spectrum, you have panic-based lows like March 2009, when the S&P riffed on the sign of the beast and traded (briefly) for 666. That was an “end of the world” sort of level, where you’re not even sure your bank’s ATM will work tomorrow.

• At the other end, there are declines like February of this year. That was caused by a badly constructed volatility-linked ETF sparking a brush fire with the dry tinder of a lazy-long market after January’s melt up. But no one worried the financial system was about to melt down, as they did 10 years ago.

As these bookends show, the future returns from buying a “panic low” correlate directly to how much distress investors feel at the time. The S&P 500 has compounded at 17% annually since March 2009, returns we haven’t otherwise seen since the 1990s. Since the February 2018 lows, the S&P is still 7% higher. Which is pretty good, but hardly in the same league (even adjusted for holding period length) as the 2009-to-now example.

So where does the current market volatility fit into this continuum, and are we even in a place where it is safe for a trader to take a shot or an investor to overweight a beaten up sector?

Three ideas, based on our monthly “VIX of” analysis of implied volatility pricing in US listed options markets and the CBOE VIX Index itself:

#1. On the S&P 500. The current VIX reading of 19.6 remains elevated, a potential buy signal for US stocks. This is smack-on average since 1990, so a 19-handle reading is not in and of itself a signal of undue “Fear”. It is, however, not far off the 20-25 range for the VIX that coincided with the April 2nd retest of the February lows for the S&P 500 in 2018.

Verdict: we’re sticking to our call that US stocks are not out of the woods yet, so a 19-20 VIX isn’t yet fear-full enough to call a bottom. Remember our recent analysis of what comes after down 4% days: stocks are, on average, flat a month later after such a drawdown. A VIX at 25 (28% higher than today’s close) is the signal to look for here.

#2. On US large cap Tech stocks. Only one sector has seen its “VIX” rise more than the market as a whole over the last month, and (naturally) it is Technology with its recent steep declines. Tech’s implied volatility (what the VIX itself measures) here is up to 23, more than double a month ago. Not even the VIX has risen by 100% in the last 30 days (it is only 60% higher).

Verdict: this data puts today’s bounce in Technology (+0.8% in a down tape) into the right framework – a temporary reprieve from deeply “fear-full” sentiment. Yesterday we outlined the Tech-Staples sector rotation currently underway and showed how it likely has further to go. The sector’s “VIX” math supports that caution because April’s levels (during the retest mentioned in point #1) were 10-15% higher than today. We like Tech, but worry the current selloff is not done and this analysis points in the same cautious direction.

#3. Small Cap vs. Large Cap US equities. Strangely enough, neither the “VIX of” the Russell 2000 or S&P 600 touched their February highs in the recent selloff. Given that the Russell is down 10% in the last month and the 600 is 11% lower, while the 500 “only” declined 5.9%, you’d expect a different reading here.

Verdict: there simply isn’t enough fear in the small cap VIX/fear index to have us believe that this asset class is yet a “Buy” relative to large caps.