Is the VIX flashing Warning or All Clear?

By David Nelson, CFA

Geopolitical turmoil has had little effect this year as traders have used any sell off to increase market exposure. The good news is the market seems to be able to push higher and sustain altitude even while in overbought territory. The bad news is complacency is high with the (VIX) SPX Options Volatility Index at some of the lowest levels seen in 5 years. Traders often use VIX futures to hedge. As markets accelerate to the downside the VIX can spike higher as the premium investors are willing to pay for protection in the options market increases.

While a low VIX can be concerning it might also be an indication we’ve entered the next leg of the bull market. After all, the VIX stayed persistently low throughout massive Bull Run in 2013 when (SPY)* S&P 500 tacked on a welcome +32%. It took more than a year but after bumping up against the ceiling several times the S&P 500 has finally broken out to new highs. The longer we can hold here, 2100 the old ceiling becomes the new support.

SPX – Ceiling becomes support

Extremely high levels in the VIX have been far more useful as an indicator of direction change. Corrections over the last 5 years have been swift with VIX levels approaching 30, a good stock index entry point for traders. Low VIX readings haven’t proved useful as an exit point for stocks. You could have made that decision at almost any point in 2013 and missed the bulk of the rally. The best I can say about it is that at 12 & below insurance is cheap and a buyer of VIX Futures has a good chance of being rewarded somewhere down the line.

The path forward

The post Brexit rally continued to push higher last week on the heels of mostly positive earnings along with mixed economic data. From a fundamental perspective valuations are stretched approaching some of the highest levels outside of the Tech bubble. In a vacuum alarm bells should be ringing but in the real world where asset classes have to compete for capital, stocks look a little more attractive. If there’s a bubble out there it lives in the bond market as institutional investors continue to pour money into negative and zero return sovereign debt.

About 25% of companies in the S&P 500 have reported so far with more than 2/3 beating on the bottom line vs 20% negative surprises. As usual top line performance is much tighter and harder to come by with 32% coming in above expectations while 21% missed.

S&P 500 earnings (Goldman)
Stock prices say more about the future than the past so maybe they’re trying to send a message that better economic data lies ahead. We’ll see. The street is skeptical with some strategists like Goldman’s David Kostin and Merrill’s Savita Subramanian saying this is, as good as it gets.

David and Savita both do excellent work so it’s important to listen to opposing views. Very little can be learned from people who think just like you. Corrections can come at any time and usually without warning. For the time being as evidenced by Brexit and a military coup in Turkey there are buyers down below. Bear markets take time to develop and despite valuation concerns a recession for now seems unlikely.

*At the time of the article funds managed by David Nelson were long SPY