Market signals like the “VIX” indicate that this rally back could get ahead of itself

Traders on the floor of the NYSE, August 8, 2022.

Source: Reuters

According to Nicholas Colas, co-founder of Data Trek Research, a key measure of stock volatility provides clues that investors should be wary of the recent market rally.

The CBOE Volatility Index hit its latest highs in mid-June and is now trading around its long-term average of 20.

At the same time, the top five sectors of the S&P 500 by market capitalization moved largely in line with the index.

Taken together, the moves are contrary to how typical market rallies have unfolded over the past few years and provide warning signs that the rally, which sent the index up around 15% from at its mid-June lows, is suspect.

“In line with previous times, the VIX was at similar levels, the correlation number should be lower. But we are there nonetheless,” Colas said in its daily client newsletter on Wednesday evening. “The VIX closes at 20 [Wednesday] promises something that equities have yet to actually deliver, namely a healthy decoupling of the sector’s price action from the overall market.”

When looking at daily 30-day returns over the past four years from technology, communication services, consumer discretionary, financials and healthcare, the sectors move in tandem with movements in the S&P 500 69% of the time, according to Colas.

In many of these periods, high correlations coincided with bear markets and vice versa. So the current conditions – the 30-day average of correlations hovering around 84%, a low VIX and a strong rebound in equities – have not followed typical market patterns.

The market rebounded strongly from those mid-June lows as investors became more comfortable with corporate earnings and hoped the Fed would not have to institute drastic rate hikes to control inflation.

But Colas said investors should beware. A market that has become complacent about the multiple challenges facing U.S. businesses, including slow growth, high inflation and tighter policy, could be hit.

“We’ve had a standing recommendation all year to consider buying stocks when the VIX is around 36 (2 standard deviations from the mean) and going light when it approaches 20 “, wrote Colas. “We’re at that last point now. While we remain optimistic, stocks look overstretched here.”

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