The VIX Tells Us Stocks are Heading for Record Highs; Why Investors Should Be Worried
The U.S. stock market has been nothing short of a roller coaster the past six months. After registering its worst quarterly drop since the Great Recession, the S&P 500 Index posted its best start to a year since 1998 this past quarter. Now, a closely-watched measure of volatility tells us that stocks are headed for record highs in the not-too-distant future.
VIX Points to Further Gains
The CBOE Volatility Index, also known as the VIX, recently completed a bearish crossover, setting the stage for another rally in the stock market. The VIX trades on a scale of 1-100, where 20-25 represents the historic average. It moves inversely with the S&P 500 Index roughly 75-80% of the time.
Basically, this means stocks rise when the VIX falls. It also means stocks tend to dip when the VIX rises. That’s because the VIX gauges expected volatility over the next 30 days. It’s a highly liquid market that can be accessed via futures, options and exchange-traded notes.
The volatility gauge has declined more than 45% this year and is currently trading well below the historic average. Although the VIX doesn’t show any propensity of returning to record lows like we saw during the height of the Trump reflation trade, it clearly shows more upside for stocks.
Here is the bearish crossover (as you can see, the 50-day simple moving average fell below the 200-day SMA last month):
The VIX made a bullish crossover in late November as stocks headed for their first bear market since the financial crisis.
And here’s the divergence pattern between the VIX and the S&P 500 Index:
Overcoming Major Resistance
Perhaps the most important aspect of the S&P 500’s recovery has been the ability to overcome a key technical hurdle that had prevented the bulls from advancing previously. Since the last time the S&P 500 hit record highs back in early October, the bulls had failed to return above 2,800 in convincing fashion. In fact, they were turned away on at least five occasions.
By eclipsing 2,800, buyers have ample runway to return to record territory. The index last peaked on October 3, where it settled at 2,925.51, according to Bloomberg data.
But record highs may not be a good sign for fundamental traders who are concerned above valuation risks. As it turns out, 2,800 wasn’t just a technical/psychological resistance; it represents the point at which the S&P 500 average per-share earnings will be 16.5 times forward earnings. That’s a strong sign that the market is overvalued. Read more: Does this Chart Spell Doom for the S&P 500 Index?
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A tumultuous first-quarter earnings season may complicate the outlook for stocks after several S&P 500 companies slashed their guidance. According to financial research firm FactSet, per-share earnings estimates have seen their largest cut since Q1 2016.
“The Q1 bottom-up EPS estimate (which is an aggregation of the median EPS estimates of all the companies in the index) dropped by 7.2% (to $37.33 from $40.21) during this period,” FactSet recently reported.
The estimated 7.2% drop is more than double the average decline in the bottom-up EPS estimate during the past five- and ten-year periods.
“Thus, the decline in the bottom-up EPS estimate recorded during the first quarter was larger than the 5-year average, the 10-year average, and the 15-year average,” the research firm said.
Investors got a taste of what’s to come after Walgreens Boots Alliance (WBA), one of the Dow’s biggest companies, reported financial results that were below analysts’ expectations. Earlier this week, the company reported per-share earnings of $1.65 on revenues of $34.53 billion for its most recent quarter. Both numbers were below forecasts. The company warned of challenging economic conditions in the year ahead.
How Investors Can Prepare
Investors should be extra careful about buying the market. Unless you are part of an employer-sponsored retirement fund (in which case you probably have to buy the market), playing the S&P 500 at 2,900 might not be a good strategy. A better option would be to invest in individual stocks, especially those in the small- and mid-cap categories. Stocks with a strong history of dividend growth are also a good option for investors looking to earn monthly income from their stock holdings.
Featured image courtesy of Shutterstock. Chart via Stockcharts.com.