Monthly Brief February 2020 – Volatility as a Signal

Monthly Brief February 2020 – Volatility as a Signal

CAPITAL MARKETS

The fastest 10% decline from a record high.  According to Deutsche Bank Global Research, that was the experience of the S&P 500 Index from February 19’s high to the close on February 27.  How does an investor respond to this type of market?  

The coronavirus, or more accurately COVID-19, has pushed many market participants to reconcile where they stand when it comes to risk taking.  Typically, investors look to the past and identify similar historical periods to use as a guide for what to expect. But what if an adequate historical example is hard to come by?  

During the stock market decline in late 2018, Fed Chairman Jerome Powell conveyed that the Federal Reserve would reverse course and begin easing monetary conditions.  The threat of tightening financial conditions (higher interest rates) had been addressed and investors resumed bidding equity markets higher.  Now, can monetary policy adequately address the economic impact of a global health concern?  

While lower rates can’t bring about an end to the transmission of a virus, they can serve to help global business navigate a slowing economic climate and be better positioned once health concerns eventually begin to subside.  Prior to the outbreak, the global economy was picking up and, while a quick snapback like that of 2018 is less likely, a global recession is far from a certainty.  Yet, continued near-term volatility in the markets is likely to persist as the uncharted waters of a global health scare continues to run its course. 

CHART OF INTEREST – Volatility as a Signal

Volatility in the equity markets often refers to market declines, and the VIX Index (Chicago Board Options Exchange Volatility Index) is a common gauge for how these market declines are playing out.  As markets move lower, the VIX Index tends to move higher based on the speed and magnitude of the market pullback.  

Should the VIX Index reach extremes, it also can be a signal for a market reversal.  Recent market activity has caused the VIX Index to spike to levels above its typical range.  While not a robust signal on its own, when combined with other factors, the VIX Index can play an important role in identifying an inflection point in the market.  Currently, the VIX Index is at 40 and, for context, the accompanying table shows the mean forward return for the S&P 500 Index following times when the VIX Index hit the corresponding levels. 

 The current levels of the VIX Index are near extremes, a typical condition from which the market has reversed and moved higher.  This is one sign that the selling pressure may begin to subside. But, while the VIX Index is insightful, where the markets go from here remains to be seen and the current state of global economies will require multiple datapoints to signal the worst is behind us. 

James Ferrin, CFA
Chief Investment Officer

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The Chicago Board Options Exchange Volatility Index (VIX Index) is a financial benchmark designed to be an up-to-the-minute market estimate of expected volatility of the S&P 500 Index, and is calculated by using the midpoint of real-time S&P 500 Index option bid/ask quotes.  For additional information regarding this index, please refer to the sponsor website at www.cboe.com/vix.

The S&P 500 Index is a stock market index based on the market capitalizations of 500 large companies having common stock listed on the New York Stock Exchange or the NASDAQ Stock Market.  For additional information regarding this index, please refer to the sponsor website at www.standardandpoors.com.

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