Wall Street Still on Edge? It May Take Months for the Fear Index to Cool Down
History suggests that the Fear Index does not quickly return to calm after a rapid spike.
Although panic seems to have subsided after last week's significant volatility in the U.S. stock market, historical guidance suggests that the market may remain tense for the coming months.
The Chicago Board Options Exchange Volatility Index (VIX), Wall Street's most closely watched fear gauge, quickly fell after reaching its highest closing level in four years last week, just as the stock market rebounded sharply from its worst plunge this year. The S&P 500 Index (SPX) rose 3% from last week's low, while the VIX hovered around 20, far below its August 5 closing level of 38.57.
Investors noted that signs of rapidly dissipating market anxiety further support the idea that last week's crash was driven by the liquidation of large leveraged positions, including yen-funded carry trades, rather than long-term concerns about global growth.
Even so, the tumultuous period of the VIX spike indicates that the market tends to remain frothy in the months following a crash, dispelling the kind of risk-taking behavior that drove asset prices higher in the first half of the year.
In fact, a Reuters analysis shows that, on average, it takes 170 trading days for the VIX to return to its long-term median of 17.6. Closing prices above 35 are associated with high levels of investor anxiety.
"Once the VIX stabilizes within a range, people will become more complacent again," said JJ Kinahan, CEO of IG North America and President of online brokerage Tastytrade. "But typically, it takes six to nine months for people to feel uneasy again."
Before the recent turmoil in the U.S. stock market this month, the S&P 500 Index had experienced a long period of calm, rising as much as 19% this year and reaching an all-time high in early July. Last month, disappointing earnings from several highly valued tech companies triggered a broad sell-off, pushing the volatility index out of the range just above 10.
More severe turbulence occurred at the end of July and early August. The Bank of Japan unexpectedly raised interest rates by 25 basis points, squeezing investors engaged in carry trades, where they borrowed yen at low cost to buy high-yielding assets like U.S. tech stocks and Bitcoin.
At the same time, investors rushed to price in the possibility of a U.S. economic slowdown after a series of concerning economic data. The S&P 500 Index fell as much as 8.5% from its July record high, just shy of the 10% threshold typically considered a correction. The index is still up 12% this year.
Mandy Xu, head of global market derivatives market intelligence at the Chicago Board Options Exchange, said that the market's quick decline and rapid rebound suggest a position-driven unwinding of risk exposure.
She said, "What we saw last Monday (August 5) was really confined to the equity and forex markets. We didn't see a corresponding large increase in other asset classes, like interest rate or credit volatility."
Investors have plenty of reasons to remain nervous in the coming months. Many are waiting for more U.S. economic data, including the Consumer Price Index (CPI) report later this week.
Uncertainty around the U.S. election in November and tensions in the Middle East also keep investors on edge.
Nicholas Colas, co-founder of DataTrek Research, is watching to see if the VIX can stay below its long-term average of 19.5 to determine whether the market has truly calmed down.
He said, "Until the VIX drops below its long-term average of 19.5 (for at least a few days), we need to respect the market’s uncertainty and humbly try to find the bottom in the market or individual stocks."
The S&P 500 nearing correction territory may be another cause for concern. Data since 1929 shows that in 28 instances where the S&P 500 was within 1.5% of confirming a correction, the index ultimately confirmed the correction in 20 cases within an average of 26 trading days. In the eight instances where a correction was not confirmed, it took an average of 61 trading days to reach a new high.
Mark Hackett, Chief of Investment Research at Nationwide, noted in a recent memo that the CPI data released on August 14 and the earnings reports from Walmart and other retailers this week could be crucial in determining investor sentiment.
He said, "Given the market’s recent heightened emotional reactions, it wouldn’t be surprising if this week’s CPI data, retailer earnings, and retail sales data trigger an exaggerated response from investors."
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