Most investors entered 2014 with cautious optimism as most analysts set modestly bullish targets on the S&P 500, which many are expecting to rise in 2014, but by no means as much as in 2013. The optimism is driven by a few things; firstly, there’s the improving U.S. economy. Secondly, there are many billions of dollars still out of the equity markets that have traditionally been in stocks. Softness elsewhere in the world, especially in emerging markets, limits the number of investment opportunities, while America’s economy seems to be improving much faster than anyone else. Finally, the Federal Reserve is still going to pump several billions of dollars into the economy, which should cause stocks to appreciate alongside other assets.
The first three days of 2014 were red for stocks, with bond yields roughly flat. Is this despite the optimism in the market, or a result of it?
One interesting note about the sell-offs is that they were not concurrent with a sudden spike in volatility. A comparison of the VIX with the S&P 500 over the first few days of 2014 shows interesting and seemingly uncorrelated movements:
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The VIX is more volatile than the S&P 500, which makes it hard to compare the two, but the historical inverse correlation between the two that gives the VIX the “fear index” nickname is not here. Of course, there’s no real reason why the VIX should remain negatively correlated with stocks forever, since it measures the premium on bullish and bearish options. However, the correlation is quite strong in times of sudden extreme movements, because it’s those moments when the market predicts more sudden extreme movements. Likewise, spikes and dips in the VIX can happen when the market is expecting a cyclical transition—that is, even if equities don’t move much, the market will signal that strong movements are to come because we are entering a new phase in the market’s cycles.
In early 2014, that has not happened. The VIX has had some panicky intraday jumps at moments when the S&P 500 fell a bit, such as around mid-morning on Jan 3rd and again on the 6th, but those spikes are relatively short lived and do not last the full day, even if the stock trendline remains bearish. In other words, volatility was not rising correspondingly with the fall in stock prices.
What does this mean? If nothing else, it means the conviction in the sell off is weak. People are selling for sure, but they do not seem to believe that the selloff is going to last very long, so there’s little need to hedge against it.
Why the low conviction? Since this is happening in early January, one possibility is profit taking from institutional investors. Momentum stocks had an amazing 2013, and many are expecting a correction in those names. With a full 2013 of trading under one’s belt, early January is a good time to make a quiet exit out of stocks that have outperformed but may need to take a breather.
If this is a cause behind the three-day sell-off, it suggests that this money is only temporarily on the sidelines, awaiting a re-entry into the market in the near future. This will reverse the dip and cause stocks to return to their bullish trajectory. If this is the case, there’s little need to hedge.
There’s no way to know if this will happen or not, but this is the signal that the VIX and the S&P 500 are giving us. Many potential shocks await—both the ISM manufacturing and service indices were soft, and two employment reports await before the end of the week. Then there’s the question of how the recent cold weather will impact consumer discretionary spending and employment. For now, those worries aren’t looming large in the market’s mind, but the market is and will always be fickle.