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Market Updates volatility Trading Education Stocks Coronavirus Interest Rates

Could The Bottom Be In For Stocks?

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With the amount of doubt and uncertainty still weighing heavy on the world, how is it that the stock market has been able to stage such a strong and impressive comeback? More importantly, is this rally sustainable, or is it an extended bear market pullback before another leg lower? 

The Chicago Board of Options Exchange Volatility Index, or the Vix, has a recently tested history of forecasting major stock market lows after trading above 80. Noted, it has only happened once before, so this truly is only the second test of this scenario.

Market Volatility At Lows

In late October of 2008, at the height of the credit crisis, the Vix traded up to a new all time high at 89.53 as the stock market was crashing. It wasn’t until early March of 2009 that the S&P 500 printed its infamous “satanic low” at 666.00, signaling the beginning of the end of the recession, and springboarding stocks into the historic 11 year bull run on the heels of a massive wall street bailout.

Volatility gradually died down, and until last month (March 2020), the Vix had not traded above 50 since March of 2009, almost exactly 11 years to the day. To put this into context; in December 2018 the stock market staged a 10% correction as the trade war with China was heating up and interest rates were rising. News headlines were all doom and gloom, and every pundit on the planet was calling for a recession, but the Vix never traded above 40. The stock market quickly rebounded and 2019 turned into another record year of gains.


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Small Caps In The Lead

The market today is not reacting in the same manner. Though this has yet to be officially labeled a recession, the Vix has gone above 80 again, and when analyzing the data, it would appear small caps could possibly be a leading indicator pointing at a retest of the March lows. 

Before this whole thing began, the Dow, Nasdaq and S&P futures all peaked in mid February at new all-time highs, then suffered losses in the 32% to 38% range after the sell-off. On the other hand, the Russell 2K printed it's all-time high on January 17, then drifted lower for nearly a month before taking close to a 45% hit during the Covid-19 panic selling. 

As selling pressure began to die down, volatility started to ease up, and the Vix topped out at 85.47 on March 18. The Russell printed a low at 948.50 the very next day, but the Dow, Nasdaq and S&P wouldn’t print their respective lows until the following week.

Since then, stocks have staged an impressive comeback. Despite record unemployment claims, an expected drop in GDP, and the high probability of big misses on earnings, the massive relief package passed by congress has so far done its job of bringing optimistic buyers back in to hold the market up. However, the Russell continues to paint a different picture.

Small caps led on the way down, and have been lagging behind the rest of the field on the way back up. As of Tuesday’s close (April 14), the Dow has taken back 51% of its losses, S&P futures are 55% back, and the Nasdaq has regained a whopping 66%, while the Russell has only reclaimed 41%. It is also the only one of these four indexes that has not yet traded back to its 50 day moving average (exponential).

It Might Be A Setup

In 2008, it took nearly five months for stocks to find a low after the VIX broke through above 80. If that pattern holds true, and follows the same time frame, it could be assumed that a retest of the March lows will come sometime in August, which also happens to coincide with when some of the Covid-19 projection models predict a second wave of infections to hit.

If a vaccine is developed by then, the stage could be set for a run lower to blow out some weak longs, setting up a possible double bottom at the March lows before making a run at the highs going into the end of the year. 

You have to keep in mind, there is an underlying fundamental flaw in the way markets are traded now. When volatility spikes, the algorithmic and HFT trading programs are shut off, and it’s up to the rest of us to make the market. When there are no buyers to hold a market up, it will naturally take the path of least resistance, usually resulting in a fast, violent move, like we just saw.

Right now, the Vix is hovering around 40 and the market is back to its old tricks of taking bad news and making good of it. With most of the world on lockdown, headline risk seems to be light, but it will be a major factor when the economy starts to open up again, so don’t overlook it.

How likely is it that this scenario will play out? Well, April is shaping up to be a monster month, and Goldman Sachs is saying that the low is in and has retracted their call for a test of the 2000 level in the S&P. That said, big moves take time to develop, and it feels like a lot of traders might have jumped back in on this rally a little too quickly.

 

Posted by John D. on April 15, 2020
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