What might the fear index be telling investors about the stock market?
Last week, the fear index that Wall Street monitors for volatility, was quite jumpy, rising nearly 30% on Friday alone when volume on the Cboe Volatility Index (VIX) also touched a record high, according to Cboe Global Markets.
The upward bound appeared to be tied first to news that former national security adviser Michael Flynn had pled guilty about lying to the FBI and reports that he was prepared to cooperate with prosecutors investigating Russian interference in U.S. elections. It peaked at 14.58, scaling a crest it hadn’t seen since mid-August, nor has touched more than a dozen times or so in 2017.
The VIX remained elevated—well, relatively at least—for much of the day on fears that the tax bill would hit a hurdle in the Senate. But later in the day, as it became more certain that the Senate had enough votes to carry the bill forward, the VIX returned to the 10-11 range, where it has spent most of the last 6 months. In the year through November, the index has averaged 10.68, compared with an average of 19.50 since 1990.
Investors Hungry for Vol?
“Friday showed us that there is a hunger for volatility,” says JJ Kinahan, TD Ameritrade’s chief market strategist.
That volatility craving comes after a long spate of complacency as the market has ticked forward to a series of all-time records. Remember that the VIX measures the market’s expectations of implied volatility over the next 30 days by using implied volatilities on options among S&P 500 Index components. Investor anxiety roils the VIX upward while calmness tempers it. When the VIX is higher, it typically means investors are willing to pay more to hedge their investments. For more on the VIX and volatility indexes, read this primer.
The Signal and the Noise?
Though the rise and fall in the VIX is linked to option prices in the S&P 500, it’s generally viewed as a fear proxy for all the major asset classes, like stocks and bonds. When equity prices rise, the VIX tends to fall, and vice versa. Friday’s leap appeared to be directly tied to what was going on in Washington, falling 1.3% in the minutes after the Flynn plea was announced. See figure 1 below. Kinahan usually refers to Washington events as “noise” because they don’t reflect the fundamentals of the markets, which are, of course, the profits and losses of equities, and the sectors in which they sit.
So why does the VIX appear to be rising on noise? Because Friday’s clatter was deemed by investors as a negative sign that the Trump White House—and everything it has promised to help cut corporate taxes and grow the economy—could be in jeopardy, according to Kinahan. The thinking goes that cutting corporate taxes should juice earnings, and provide a boost to stock prices.
The VIX subsided after the tax bill cleared its first major hurdle. Though the House and the Senate must hammer out one bill between their two proposals, the VIX now seems to be telling investors that the likelihood of a compromised bill reaching President Trump’s pen this month is high.
But don’t let that complacency lull you into a false sense of perceived VIX security. The VIX may move to higher ground amid a level of flux this month, Kinahan says. That might be especially true if the House and Senate tax bills don’t get reconciled by Christmas, as Senate leaders have promised. What’s more, trading can be heavy toward the end of the year, as investors rebalance their portfolios for tax considerations, and fund managers shift out of lagging positions in favor of those that have performed well throughout the year.
“As we sort out the sector winners from the sector losers for the year, we may see an added level of volatility as people start to adjust their portfolios to invest in these sector winners,” Kinahan says.
Sift Through Sector Candidates
Use Stock Screener to narrow selections based on sectors. Log in to your account at tdameritrade.com > Research & Ideas > Screeners > Stocks.