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A Couple of Risk-Off Days Do Not Make a Crisis – Yet


Chief Strategist at Interactive Brokers

Yesterday was a difficult one for many investors and traders.  Major indices were meandering lower in the morning and early afternoon after a stronger than expected ADP report, but selling accelerated dramatically after the 2 PM (EST) release of the minutes of the last FOMC meeting.  The S&P 500 Index (SPX) closed about 2% lower and the NASDAQ 100 (NDX) fell just over 3%, with the bulk of those drops occurring in the last 2 hours of trading.  The FOMC minutes indicated a greater willingness to raise rates and shrink the Federal Reserve’s balance sheet than their last meeting statement implied.  Markets don’t react well to reminders that monetary stimulus will be abating, and react even worse to negative surprises from the Fed.  Taken in that light, yesterday’s drop should not be at all surprising.

Although yesterday’s drops were sobering, it is important to keep them in perspective.  For starters, the move in SPX is little more than a retracement of the recent “Santa Claus” rally.   The steeper drop in NDX put us about 3.3% below its pre-holiday level, meaning that it was one day quicker to retrace a period of gains on light volumes. 

SPX (white) and NDX (blue), Intraday charts since December 23, 2021

SPX (white) and NDX (blue), Intraday charts since December 23, 2021

Source: Bloomberg

The logic behind NDX’s underperformance is that the mega-cap tech shares that dominate that index representing about 50% of its market capitalization weighting vs. about 25% for SPX – have been under pressure.  The proximate cause is the perception that higher interest rates have a disproportionately negative effect on the companies with premium valuations, something we discussed earlier this week.  In contrast, SPX has substantial weightings in finance and energy that have provided ballast to the index.  Both of those sectors, and value stocks in general, have been outperforming growth stocks.  Value stocks are largely absent from NDX.  It helped NDX outperform SPX over recent years, but causes underperformance if investors rotate their holdings from growth into value. 

Not surprisingly, we saw VXN[i] move sharply higher relative to VIX in recent sessions.  That VXN rose more quickly than VIX should not be surprising on a day when NDX fell 3% and SPX fell 2%, but the historical volatility of NDX has been higher than that of SPX for the past few weeks.   Some of that increased volatility can be attributed to the extraordinary gyrations in Tesla (TSLA), which is about 4.5% of NDX and about 2.2% of SPX, but the chart above shows a more volatile blue line compared to the white.  Even though VXN is constructed to be a view of the market’s anticipated volatility over the next 30 days, just like VIX, historical and current volatility play heavily into traders’ mentality.  The spread between VXN and VIX reflect the changing viewpoints about investor perceptions about the relative safety of mega-cap tech stocks vis-à-vis the market as a whole, as the chart below shows:

VIX – VXN, Past 3 Months

VIX – VXN, Past 3 Months

Source: Bloomberg

Think back to the end of November.  Mega-cap tech stocks were viewed as bastions of stability amidst rising inflationary pressures because they could pass along price increases to their customers.  Since then, bond yields rose, moving the focus to valuation concerns.  Yet while the recent change in the spread between the two volatility measures has undergone a dramatic shift, the spread has been prone to change dramatically over the past two years:

VIX – VXN, Past 2 Years

VIX – VXN, Past 2 Years

Source: Bloomberg

From this perspective, the recent move is relatively dramatic, but hardly without precedent.  Note the wild moves in the aftermath of the initial Covid crisis.  After March of 2020, the tech sector was perceived as a relative bastion of stability, pushing VIX sharply higher relative to VXN.  If investors had a change of mindset that changed their fundament perception of the relatively crowded tech sector, the rush to exits from a crowded trade could have a profound effect on tech volatility specifically and market volatility over all.

In the meantime, VIX futures show little true concern about yesterday’s events.  While the spot index and the front end of the curve has risen over the past week, the bulk of the futures remain relatively unchanged over that time.  More importantly, the curve remains steeply upward sloping.  An inverted curve, or even a flattish one, indicates a shortage of available volatility protection.  We saw that as recently as a month ago, but not now:

VIX Futures Curves, Today (green), Yesterday (orange), Last Week (blue), Last Month (red)

VIX Futures Curves, Today (green), Yesterday (orange), Last Week (blue), Last Month (white)

Source: Bloomberg

Market expectations for short and intermediate term volatility remain well below where they were during the mini-selloff of early December.  Even after the FOMC minutes those expectations barely budged.  Until or unless we see VIX futures either rise to those levels we saw last month, or we see an inversion in the futures curve, it is too early to say that investors are truly nervous.

Are you glass half-full, thinking that the relative complacency is a sign of strength, or glass half-empty, thinking that the complacency makes us more susceptible to further risk aversion and selling?

[i] The CBOE NDX Volatility Index. Quite the oxymoron, no?

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