Who’s afraid of the big, bad bear? Not Paul Jackson and András Vig of Source Research, who remain bullish on U.S. equities. In their November 8th report, the analysts suggest that U.S. stock markets may yet have some way to run despite the looming Fed rate hike, as rising bond yields are likely to buoy stocks as well, at least for a while.
In terms of the Fed rate hike, the Source analysts note that, based on Bloomberg data, the market’s implied probability of a December Fed rate hike moved up this week from 50% to 68%.
Contrarian view on higher bond yields and stocks
Jackson and Vig flesh out their contrarian argument below: “Invariably during investor meetings, mention of Fed rate hikes and rising bond yields brings a knowing look, suggesting that equities are doomed. Though such views were forged by the experience of many decades, they are not supported by more recent evidence. Figure 2 suggests the correlation between US stock prices and bond yields has tended to be positive since the turn of the century. If it remains positive, equities will continue to rise along with bond yields.”
VIX versus SKEW
The Source report also notes that the recent move up in U.S. equity markets has also seen a decline in implied volatility, as the VIX index has now slipped below 15, after a peak of 53 in late August. Although this seems to suggest a normalization of investor sentiment, another index, SKEW, is pushing up against historical highs.
Of note, VIX measures market projections of future volatility, while SKEW reflects the estimated likelihood of tail-risk events (range between 100 and 150 with higher values indicating greater cost to protect against major tail-risk events).
Jackson and Vig note it’s possible that given the market meltdown earlier this year, investors may be worried about another “accident” in China. However, Figure 1 does not offer much support to this perspective, as “high VIX is often associated with high SKEW (and high future returns) but high SKEW can also be associated with low VIX (as now). The best that can be said is that the current combination is often (but not always) associated with positive (but limited) future returns on the S&P 500.”