What Last Week's VIX Plunge Really Means for the Stock Market

The CBOE Volatility Index (VIX) hit its lowest level in a decade, but that doesn't mean a stock market top is at hand

May 1, 2017 at 8:48 AM
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During the course of last week, we were bombarded with enough headlines to make our heads spin. When approaching the stock market, for newbies and seasoned veterans alike, it can be very appealing -- and even seem rational -- to digest every headline and consume as much news and information as possible. What you will eventually learn is that this habit will usually give you a headache, lose you money, or at the very least, keep you from doing things that are meaningful. For those who work hard enough at this pursuit, you might even achieve all three simultaneously!

News providers earn their living from selling advertisements to companies that pay them based on the amount of attention their content attracts. That's it. They don't earn money from predicting the movement of stocks, how long the bull market will last, when the bear market will begin, or how relevant the story is to the stock market or your investment portfolio. That is precisely why anyone watching business news for the past few weeks has probably seen a certain passenger being dragged off a certain plane more times than I can count.

So, for the sake of catering to those who aren't quite ready to give up their overly intoxicating consumption of headlines, let's get this review of last week's big news stories out of the way. It will be short, and I promise it will be painful.

  • Emmanuel Macron and anti-EU candidate Marine Le Pen were voted through to the next round of the French election. Most believe Macron will win this match-up easily, so there was a sigh of relief from European and U.S. investors on Monday.
  • The Trump administration announced tariffs of around 20% on Canadian lumber shipped to the U.S.
  • The Trump administration announced the $1.4 billion down payment for the border wall could be taken off the table and negotiated in September instead.
  • A tax plan outline from the president was released, highlighted by a 15% corporate tax rate, 10% on repatriated earnings, and a big increase in individual standard deduction. It won't be fully negotiated by Congress until later this year.
  • The Bank of Japan and European Central Bank both left their monetary policies unchanged.
  • President Trump warned a "major conflict with North Korea" may be on the horizon.
  • Congress agreed to kick the can down the road on the spending bill ... for one week.
  • First-quarter GDP increased at a 0.7% annualized rate, which was below expectations and the lowest in three years. Growth in personal expenditures was the weakest in seven years.
Now, let's take a step back to see what all of this means for the stock market, starting with the bigger picture. The fundamentals remain strong, and have improved during the past few years. Valuations are very high, whether you are looking at the price/earnings ratio, CAPE ratio, or others. The important thing to note is that valuations are historically good indicators of long-term performance -- but over shorter time periods, they aren't the best timing tools.

Corporate profits were declining for five quarters in a row, but turned around in early 2016. Sales and margins of S&P 500 companies continue to be strong, and at or near previous highs; earnings for the recent quarter are coming in just ahead of expectations, and it should be another positive quarter.

The economy has been growing at a slow and steady rate for the past seven years around that 2% area. From 1947 to 2016, the GDP growth rate averaged 3.22%, so we are clearly seeing slower-than-normal growth during this recent recovery. One factor is that consumers are saving more than in years past, and historically, major economic tops occurred when personal consumption was much higher. Slow growth may be more sustainable for a longer period of time under these circumstances.

us gdp growth rate 0428

The unemployment rate is also at its lowest level since 2007, while inflation is near the Fed's target rate of 2% -- hence why we have started to see rate hikes. Speaking of rate hikes, the CME Group 30-day Fed funds futures indicate that investors expect two more rate hikes before year-end.

The labor participation rate has started to tick higher in 2017, but is still coming off incredibly low levels. Baby boomers are still in retirement, and millennials are staying in school or choosing not to work yet, but are also just entering their family formation years. Automation also can create time lags as workers take time to develop new skills as industries change. Any or all of these factors improving could further bolster long-term growth.

us labor force participation rate 0428

For a weekly update, that is admittedly a bigger scope than necessary. Utilizing technical and sentiment analysis can help us dial it down to a shorter time frame, though. The long-term trend on all major U.S. stock market indexes remains strongly bullish, and most are at or near all-time highs, with long-term moving averages all trending upward.

Last week, the Nasdaq Composite (COMP - 6,047.61) and Russell 2000 Index (RUT - 1,400.43) took leadership roles and surged to new all-time highs. The S&P 500 Index (SPX - 2,384.20) is still contending with previous resistance in the 2,385-2,400 area, which is the site of its prior all-time high, and which acted as resistance on March 15 -- the day of the Federal Reserve's first rate hike this year. In fact, the closing price on March 15 was 2,385, and the index failed to close above the March 15 high this week. This will be an area that may create some selling pressure in the short term.

spx daily chart 0428
Chart courtesy of StockCharts.com

Speaking of the surge in prices on Monday and Tuesday, the CBOE Volatility Index (VIX - 10.82) price action was noteworthy as well. On Monday, the VIX dropped nearly 26%. I wanted to take a look at what's happened previously when VIX has reached these extremely low levels. Going back to 1990, the following table shows times when the VIX closed below 10.50 after being above it for at least a month.

spx returns after vix 10.50 0428

This has only happened five times before, so not a huge sample size. When this did occur, the SPX underperformed its usual returns over the following one-week, one-month, and three-month time frames. Despite the underperformance, it's important to note that the only time period where the SPX suffered a negative median return was one week, and during that week, the index was positive only 40% of the time. The SPX still performed well long-term, as it was positive 80% of the time six months after one of these signals, and 100% of the time one year later.

Of course, this isn't absolute proof -- but this data does show us that when VIX hits an extreme low, it hasn't historically indicated a major stock market top, and the trend usually continues higher. The other interesting thing to note is that while the post-signal returns over six months and 12 months are similar to anytime returns, we can see that the standard deviation following a VIX 10.50 signal is less than half of what it is typically. Less risk for the same return is nothing to complain about!

Sentiment is definitely more bullish that it was in previous years. Short interest on SPX stocks has declined significantly during the past six months, and is lower than almost 80% of the readings during the past year. Short interest is also at relatively low levels on other equity indexes, indicating there may not be as much fuel for potential short-covering as there once was.

Likewise, the Yale Confidence survey shows that institutional investors are extremely bullish, and the Investors Intelligence survey is nearing levels that we have historically viewed as extreme optimism.

investors intelligence survey with spx 0428

On the other hand, the BofA-Merrill Lynch survey of global fund managers also indicates that fund managers have moved to dramatically underweight U.S. equities in April.  In fact, they are -20% underweight, which is the lowest level since January 2008. Managers continue to be extremely underweight bonds, which they have been for months. We also look at the Commitments of Traders (CoT) reports, which show that large speculators are still very long the U.S. dollar, but have covered their short positions on the 10-year note from several months ago.

So we're seeing some mixed signals on sentiment, but I would not categorize the mood as overly euphoric at this point. In the short term, the historically low VIX, combined with the SPX trading near its post-Fed closing price on March 15 and just below its previous all-time high, could create an environment where market participants take a little risk off the table. But based on some of the bigger-picture economic and fundamental improvements, along with the index's strong uptrend, these SPX overhead levels have a higher probability of being a speed bump than a ceiling for U.S. equities. Betting on higher rates and a higher U.S. dollar also continue to be relatively crowded trades, so they're ones I would avoid at this point.

This week is another busy one, with a lot of earnings reports and very important economic events. On Monday, the PCE inflation data is released, and on Wednesday is the Fed's interest rate decision. For what it's worth, Fed funds futures indicate most don't believe a rate hike will occur at this meeting, and we won't see the second hike of 2017 until at least June. To round out the week, the monthly nonfarm payrolls report for April will be released, as well.

To reward those who have stuck it out until the end of this market commentary, I will grace you with a wonderful and meaningless headline from last week: Global Market Cap Hits $50 Trillion for the First Time Ever. Congrats, humans.

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