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Volatility Update: Will Earnings Soothe or Scare?

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January 14, 2016
January trading and the new year: volatility is high in a jittery market. Earnings are coming up

The seal is barely broken on 2016, and already the S&P 500 (SPX) is down roughly 7% year to date. While SPX dropped, many measures of market volatility surged, driven by oil price weakness and China’s economic woes.

Now focus turns to the potentially grim prospect of the Q4 earnings reporting season, which Wall Street economists expect to lag the year-earlier comparison. Analysts polled by Zacks Investment Research expect overall Q4 earnings to be down 7.4% versus a year ago on a 4.6% decline in revenue. It’s one of the weakest outlooks for Q4 in recent memory, according to the research firm.

Weak earnings could simply pile on to a jittery stock market. Or, a selling-weary market could embrace any results that beat these low expectations.

Big Move for Vol

Broad-market volatility is elevated heading into earnings time. The CBOE Volatility Index (VIX) was back in the mid-20s last week after the SPX fell to two-month lows. The market’s “fear gauge” rose above 25 for only the second time since late September and had added more than 10 points, or 73%, from its late-December lows. VIX remains at the upper end of its three-month range.

CBOE Volatility Index kicking off 2016

FIGURE 1: VOLATILITY ROARS TO LIFE.

This one-year view of the CBOE Volatility Index (VIX) shows the “fear gauge” pushing 23 to start 2016. Data source: CBOE. Chart source: TD Ameritrade’s thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

VIX wasn’t the only volatility gauge moving higher in the first week of 2016. Given the recent focus on China’s economy and equities market, it’s not surprising to see that the “VIX” for China, the CBOE China ETF Volatility Index (VXFXI), was among the bigger movers shown in the table below. It rose nearly 50% in the first week of this year. Likewise, the CBOE Emerging Markets ETF Volatility Index (VXEEM) rose 33.6%. Meanwhile, with crude oil prices falling to 11-year lows, the CBOE Crude Oil Volatility Index (OVX) is up 18% year to date. In fact, nearly every barometer for market volatility moved higher in the first five trading days of 2016.



YTD*
S&P 500 Volatility
VIX
27.1%
NASDAQ 100 Volatility
VXN
27.4%
Dow Volatility
VXD 30.3%
Russell Small Cap Volatility
RVX
19.4%
Oil Volatility
OVX 18.2%
Gold Volatility
GVZ
7.0%
Emerging Markets Volatility
VXEEM 33.6%
Brazil Volatility
VXEWZ
7.3%
Euro Currency Volatility
EVZ 3.2%
China Volatility
VXFXI
48.9%
*through morning trading, January 8, 2016; Source: CBOE

Crude’s slide is predicted to take a bite out of energy-sector earnings. Energy was the worst-performing sector during last week’s market decline (see below).


YTD*
Telecom
-3.9%
Financials
-5.6%
Technology
-4.9%
Energy
-6.4%
Materials
-6.3%
Consumer Staples
-2.0%
Consumer Discretionary
-4.2%
Health Care
-3.9%
Utilities
-0.2%
Industrials
-4.9%
S&P 500
-4.6%
*through morning trading, January 8, 2016; Source: CBOE

Yet, while some groups held up better than others during the early-2016 drop, all market sectors moved lower. Some market watchers are quick to place the blame on falling crude oil prices and worries about China, but this looming earnings doom could have something to do with the jitters. That, in turn, could be setting the bar just low enough that many companies could top Street estimates when the actual numbers come out.  

Tom White's RED Option Commentary


Editor's Note: As of October 3, 2016, RED Option is now TradeWise.

With SPX price/earnings levels at the high end of historical averages, the reversal lower for equities and subsequent volatility rise is not surprising. Lower oil prices (/CL)—trading at multi-year lows—have put pressure on the markets and the economy—limiting healthy inflation that could puff up an improving economy. Add this: the durability of that economic improvement is even being questioned, as industry estimates for gross domestic product (GDP) have been lowered.

One bright spot is that job growth is on the rise and the unemployment rate is near full-employment levels, sitting close to 5%, according to recent reports.

Perhaps the market simply has it right? Option volatility may be warranted by this host of headwinds. The price of short-term protection appears to be rising; this is what happens when equities slide. At the same time, price levels on some stocks are in correction territory and valuations are coming down to potentially attractive entry levels.

In fact, many are asking if the market is in store for some relief as the SPX nears a 10% drop from the all-time highs seen last May. We at RED Option like the increased option market volatility. Why? It creates potential new opportunities for our strategy recommendations, many of which offer risk-defined features that may change the way some traders look at volatility. 

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