VXX’s Bullish Crossover Signals the Emergence of a New Market Paradigm

A key measure of expected volatility may have just confirmed the start of the end for the so-called Trump reflation rally. With contango out of the picture, the iPath S&P 500 VIX Short-Term Futures ETN (VXX) is showing rare stability – and possibly signaling the emergence of a new market paradigm.

The Return of Volatility

VXX, which provides directional exposure to the CBOE VIX Volatility Index, experienced a bullish crossover on Thursday, with the 50-day simple moving average (SMA) crossing the 200-day SMA. The index itself closed at 47.31. As the following chart illustrates, VXX has maintained consistently higher levels since early February when volatility surged.

The bullish crossover is significant for several reasons, chief being that the VXX is closely tied to the current value of the S&P VIX Short-Term Futures Total Return. Since market participants cannot trade the CBOE VIX directly, this hypothetical portfolio is considered the next closest thing. In other words, it provides the market’s overall view of the future direction of the CBOE VIX. The CBOE VIX surged nearly 81% in the first quarter to settle right around its historical average.

From an investment perspective, the VXX essentially operates as a long position in first- and second-month VIX futures contracts that roll daily. Investors with bullish bets on volatility usually buy the VXX, but hold it for short periods because it decays heavily over time due to contango. When volatility spikes, the normal state of contango is disrupted, as the following chart shows:


Source: vixcentral.com

Under normal conditions of contango, the futures price is above the cash price, with each futures month being more expensive than the previous.

The return of volatility makes the VXX much more appealing from an investment perspective, but not as a buy-and-hold strategy. Time decay makes holding VXX very risky. One way to overcome this is to implement short holding periods and limit buys to significant spikes in the VIX/VXX.

We are Not in a Bear Market

While recent movements in the VXX suggest that the stock market is in a temporary downturn or possibly a broader correction, the case for a bear market is weak. Looking at official government data, we see a gradually improving economy and signs of rising inflation. On the earnings front, we are also witnessing stronger profit and revenue growth for S&P 500 companies. To that end, financial research firm FactSet is forecasting earnings growth of 17.3% for Wall Street during Q1 2018. That would mark the best quarter in seven years.

What VXX does signal is the end of complacency and tranquil market conditions that we’ve grown accustomed to for the last two years. The Trump administration is now in position to implement much of what it promised during the 2016 election campaign. We saw just how difficult it was to pass tax reform. As recent developments show, the White House will have a harder time convincing markets that protectionism is in their best interest.

The so-called “trade war” signals a profound paradigm shift for the U.S. economy. Although many nations have called out China’s unfair trade practices, few have sought to address them given Beijing’s growing dominance on the international stage. Trump holding China to account may be necessary, but it will be a difficult sell in a market that is largely averse to protectionism.

That said, we are not in a bear market – at least, not yet. By the end of Q1, the S&P 500 Index was down 8% from record levels. That’s still a long ways away from meeting the technical definition of a bear market, which usually requires a drop of 20% or more from previous peaks.

Featured image courtesy of Shutterstock. 

Author:
Chief Editor to Hacked.com and Contributor to CCN.com, Sam Bourgi has spent the past nine years focused on economics, markets and cryptocurrencies. His work has been featured in and cited by some of the world's leading newscasts, including Barron's, CBOE and Forbes. Avid crypto watchers and those with a libertarian persuasion can follow him on twitter at @hsbourgi