Is the Market Scared?
One of the market’s main headscratchers: how can the same piece of news trigger opposite reactions? How can an announcement in employment numbers be interpreted as a positive sign of consumer strength, or, most likely, a negative sign of Fed hawkishness?
The answer is in the context. Over the past two decades, investors and strategists have widely adopted indicators that track the “mood” of the market— the likelihood that new data will be interpreted as good or bad. Quantifying the aggregate view of millions of investors is challenging, but, lucky for us, somebody already did the work!
A very simple “fear indicator” is the VIX. Although technically complex, it summarizes everything as a simple number that investors track without getting in the formulaic weeds. Generally, a low VIX (i.e., under 20) is usually associated with an optimistic market, whereas a higher VIX (i.e., over 20) is associated with a pessimistic market.
During 2022, the VIX has averaged 26.2, consistent with the dreadful year we’ve had, whereas, throughout the years 2010-2019 we saw a 16.9 VIX, in line with the decade-long rally. Dramatic spikes in the VIX were seen at the start of the COVID-19 pandemic and reached temporary highs at the start of the decade with the sovereign crisis in Europe.
A longer-term view of the economy and the markets– both bonds and equities– is reflected in the spread between the 2yr and 10yr Treasury notes and bonds. In a normal market, investors require a higher rate for lending money to the US government for 10yrs compared to only 2yrs. The difference between those two yields is the 2yr-to-10yr spread.
In good times, with solid and healthy growth in the economy– and thus higher future earnings’ estimates– the spread widens. The reasons for this expansion are as many as economists in Wall Street! There is a funds flow effect as investors dump long-term bonds to favor equities. Also, as the economy accelerates and the risk of overheating rises, long-term bond investors worry about future rate rises, pricing that in the 10yr yield.
On the other hand, as economists predict a slowdown, the spread narrows; we may even see negative numbers if the economy is expected to enter a recession. This is known as the “inverted yield curve.”
Despite the VIX being a tool used mostly to monitor the market’s mood, investors can also get direct exposure in the ETF market. For investors that think the market is as fearful as it gets and expect a pullback in the VIX, the SVXY is a short-VIX fund. Despite a modest ~$300m market cap, the SVXY is relatively liquid with ~$100m traded daily. However, if investors remain bearish or want to hedge a long position in the market, the VIXY is a straightforward ETF that tracks the VIX dollar-per-dollar.
What could go wrong with this type of strategy?
The VIX and the 2yr-to-10yr spread are indicators of the market’s risk aversion or appetite more than direct investment strategies. Investors that trade the VIX– either long or short– are effectively trading in an indirect, highly complex measure of volatility in the options market with very limited visibility for most investors (nearly everybody except highly trained specialists).
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