Written By: Adrian Moore – Forex Focus
Volatility has made its return to the United States’ stock market, albeit not the way bullish investors would like. A recent decline in the US equities market erased the gains of many weeks in a matter of days in both the Dow Jones Industrial Average and the S&P 500 indices. The pace of the decline has been unprecedented, to the alarm of investors. Yet, such a decline was bound to happen at one point in time or another due to changing market conditions and less accommodative monetary policy.
The calculation of the S&P 500
By standard, the S&P 500 is calculated based on the adjusted market capitalization of US firms. The companies with bigger market shares have a heavier influence on the index than smaller firms since they have a bigger weight in it. The S&P 500 is considered as a benchmark for US equities. Yet fluctuations in the market capitalization of smaller firms have little effect on it when bigger companies are growing, which was the case during the prolonged rise.
The equally weighted SP 500 Index reveals different insights. It diverged significantly last year from the Standard S&P 500 Index, indicating that a bearish move was in the line of sight, although timing this move was near to impossible.
The VIX has been low for quite some time.
The decline in US equities has been associated with a breakout to the upside in the VIX (CBOE Volatility Index), which measures volatility. The index had been showing readings below 32 since 2015 (often below 18) and was moving in a declining channel, until it broke out recently. This breakout is almost similar in its length to the rise in volatility in August 2015. Although the rise in volatility was much less extended than the one during 2008, it was still significant. The breakout in January 2018 followed an extended period of low volatility (three years). An extended bull market and extended period of low volatility are two important signals of an impending market correction.
Today, the volatility has dropped back down, and equities seem to be recovering. Yet in the longer term, we may see more upswings in volatility that are mostly associated with changing market cycles.
Moreover, the SKEW Index has been moving above 120—which entails more abnormal returns—since 2014. In 2017, it almost reached 148 (a very high reading, considering that the highest value in the SKEW Index is 150). The market’s response was small at the time, and the upside move continued. An adjustment in valuations was on the horizon.
An inverse relationship between volatility and liquidity
Although many factors affect the level of volatility, liquidity is an important one. In simple terms, lower liquidity leads to higher volatility. As the movements in the two major equity indices (Dow Jones and S&P 500) were extended, the risk of more increase became heightened, especially as the S&P 500 has been on its longest uptrend without a 5-percent decline since the Great Depression in 1929. The rise required more buyers to be sustained, but with the absence of those, liquidity declined and volatility spiked, taking stocks downwards.
Intervention following economic recovery
As GDP (gross domestic product) figures were improving in both the US and Europe, a change in monetary policy was warranted. The announcement of tax cuts in the US following the announcement of positive GDP growth there indicated that the fiscal budget might suffer as a result. Strategists from Goldman Sachs and Stifel expected an imminent correction. Central banks have been gradually withdrawing their support and moving towards less dovish policies—a factor that would lead to a decline in stock valuations.
Following the very easy monetary policies implemented after the crisis, the US 10-year Treasury note reached its highest yield level in around four years. At the same time, the yield on the 10-year Japanese note also rose to its highest level in around eight months. As the yields of the two notes increased together at the same time, the correlation between the US 10-year note yield and the USD/JPY currency pair has declined, signifying an approaching correction with the drop in the US dollar.
The currency markets
The dollar has been declining in value against a basket of currencies steadily since the beginning of 2017, when it topped out. This decline promoted a recovery of the euro from its low levels. However, the decline in US dollar value has been associated with an increase in stock values as measured by the S&P 500. Historically, the correlation between the two indices (US Dollar Index and S&P 500) has been around 0.38 on average, but recently it seems from the chart that it has become negative. This growing divergence between the US Dollar Index and the S&P 500 Index would definitely have an impact on stock valuations and perhaps incentivize a correction.
In this chart, the S&P 500 Index (orange) is clearly diverging in its direction from the US Dollar Index.
There have been multiple divergences in many markets, indicating that the current rise in US equities might not continue for long. Even today, with a small recovery after the decline, there remains a chance of a continuation to the downside. Central banks, led by the Federal Reserve, are moving towards more hawkish policies with rising interest rates and less stimulus. They are attempting to manage bubbles before they reach extreme levels, which warrants a move to the downside. 2018 has begun with a different story from 2017, and investors have yet to see the rest of it unfold.