by Craig Basinger, CFA; Gareth Watson, CFA; Derek Benedet, CMT; Chris Kerlow, CFA; Shane Obata
Markets rallied on Friday to close out the week at a new all-time high for the S&P 500. The gain was driven mainly by the day’s impressive jobs numbers out of the U.S.. The continuing upward trend is encouraging, but more impressive, in our opinion, is the fact the FTSE 100 managed to make a 52 week high on Friday. Following the Brexit results, who would have guessed the market would have reacted as positively has it has. The pound of course is another matter.
Despite the recent gains, investor sentiment is not terribly optimistic. This week’s AAII Bullish Sentiment reading was 29.79, well below what we would consider an average reading. The lack of any excessive optimism removes some doubt that we are at an emotionally driven market top, but the recent lack of volatility has caught our attention.
With the VIX index at 11.2, it’s now at new lows for the year — right around where it was trading last August. For those with short memories, within a matter of a couple of weeks we saw the VIX hit a low of 10.18 then shoot right up to a high of 53.29. The volatility spike occurred as markets fell over 10% in just about a week. Indeed, based on recent memory, sometimes too little volatility can be scary too.
The S&P 500, along with many other markets, has been stuck in an extremely tight trading range for the past couple of weeks. From a technical standpoint, some consolidation following the impressive move higher is expected. Consolidations can take many forms and the shapes or patterns of these consolidations is always some trade-off between price and time. They can be short and quick pull-backs, or longer drawn out consolidations with bulls and bears fighting it out in an ever tightening range. Sometimes, like the most recent period, the consolidation is almost purely a function of time. The bulls and bears seem at ease at current levels, and just need time to cool off. Given the weather lately, it’s understandable.
The index looks to be breaking out of what might just be one of the narrowest three-week trading ranges since 1950. We highlighted this fact through one of this week’s Charts of the Day in our Daily Launch Pad publication. If you haven’t signed up, click here to be added to our daily distribution list. Just because we’re witnessing an abnormally tight trading range, it does not mean that a significant reversal is imminent. This is the summer doldrums after all, where volumes are seasonally quite weak.
We did a little data sleuthing to see just how common it is for the markets to be stuck in such a tight range. We tracked the difference between the high and low over trailing two week periods going back to 1950. Over the period studied, the average variance was 3.26% with a median reading of 2.77%. As you can see, there is a definite skew to the right in the. Last week the variance fell to very uncommon levels, dipping down to 0.52% for two consecutive days. Over the past 56 years, the two week variance was this low only 0.14% of the time — 24 days to be specific. In these tight trading ranges, there really isn’t any market direction.
Future performance following the two-week sideways moves proved to be well below average. The average three and six month performance was just 0.52% and 0.50% respectively whenever the variance dipped below 0.55%. Interestingly, the best performance on average comes after a period of elevated volatility. Buying the dip usually does work out. Knowing what a dip is and what the beginning of a bear market is another story.
One thing is clear, the longer this range progresses, the more uncertainty will creep into investors’ minds. Not a good thing. We like trends that move up and to the right. Friday’s move higher, encouragingly, appears to be breaking out of the ‘box’. A strong open this week will do wonders for investor confidence. Tight trading ranges are an opportunity, one in which if you are patient, you can wait and see the market tip their hand.
Complacency in Option Land
The VIX is often referenced as the bellwether for measuring market volatility. It is the weighted average of the implied volatility priced into S&P 500 near term index options. So essentially, if you were trading index options, the VIX measures how much volatility is expected to occur. The reason we are writing about this is the VIX traded down to 11.2 on Friday, translating into 11.2% annualized volatility being priced into near-term S&P 500 options contracts. That is very low, the lowest in the past year and the lowest going back to the summer of 2014. This raises the question as to whether the market is now too complacent or, more importantly, does a low implied volatility in the market mean there is trouble ahead? No.
Okay, I will expand. Periods of very low volatility have preceded market selloffs and in other occurrences, markets continue to move higher. The chart to the right is the S&P 500 and the VIX over the past five years or so. We looked at each time the VIX traded below 12 (red circles) and found that there was really little predictive value. The table below outlines the subsequent return for the S&P 500 following those events. Sure the average return over the next 30 days is ever so slightly negative but this is not the case 60 or 90 days out. Plus, half the 30 days returns were positive: clearly no silver bullet for the market.
Charts are sourced to Bloomberg unless otherwise noted.
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