Like the wayward son returning home from a land faraway, our equity market – after a recent retest of the August lows – came to its senses and began an unremitted sprint back of 6% in a matter of five days. Similar to the rallies of months gone by, this snap-back in the S&P 500 came with little warning and less reason. Stock volumes were borderline decent during this latest move upwards – it had a “squeezy” feel to it - “social buying” as it were – full of the low-conviction chasing that we’ve all grown overly accustomed to.
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Despite all the equity market volatility, I’m deeply fascinated with the price stability in crude oil over the last four weeks. Perhaps the market is telling us that the cure for low prices is indeed low prices as global oil demand has responded quickly to the price drop. It’s just a matter of time where the “chatter” over market balance will shift from excess supply to that of excess demand. In the short-term, look for the vast storage overhang to act as a low ceiling for crude prices. Medium-term, I’m betting for slightly higher average prices as I don’t think the “perfect (supply) storm” that we recently witnessed will have the ability to repeat itself.
Why is everyone watching the Fed? With Fed Fund futures pricing in a 10% chance of an October lift-off while a 35% chance of a hike in December, there’s not much room for the FOMC to spring a surprise. On the other hand, we have both the Bank of Japan (BoJ) and the European Central Bank (ECB) to provide us with their reaction to recent financial events in the form of policy decisions – BOJ on October 7th & 30th and the ECB October 22nd. Will it be possible for the BoJ to sweep the recent weakening of inflation and wages under the rug, and still maintain more easing? Will the ECB be able to reignite the once-held optimism that liquidity would drive equity markets higher or will the twin drag anchors of slowing emerging market growth and the knock-on effects of capital spending cuts make additional QE measures deemed as useless?
On August 24th, the VIX climbed to a year-to-date high of 40.74 before succumbing to gravity and now trades at/around 20.0; levels not seen since August 20th. But, what does the VIX trading at 20 mean? In an effort to truly understand VIX, it is critical to stress that VIX is an attempt—a mere snapshot of looking ahead—assessing volatility that we look forward to see. It is not in any way predictive or backward-facing. The VIX is quoted in percentage terms and predicts the expected movement in the S&P 500 stock index over the next 30-day period, which is then annualized.
For example, if the VIX is 20, this represents an expected change of 20% in either direction over the next year with a 68.2% certainty. To break that down to a shorter time period we multiply the annualized number by the square root of time. In this case that means we multiply 20% by the square root of (30 / 252), and come up with 6.90%. More precisely, due to the math of the probability distribution, S&P 500 index options are priced (if the VIX is 20) with the assumption of a 68% certainty (one standard deviation) that the magnitude of the S&P 500’s 30-day return will be less than 6.90%.
U.S. dollar strength? Reviewing the U.S. dollar through the lens of the U.S. dollar index (DXY), it would appear the much publicized rally is far in the rearview mirror as it peaked in mid-April (100.39) and since then has wandered a little lower – resting comfortably within the mid 90.00’s area. However, looking through the broad scope of currencies including Brazilian Real (-25%), Australian Dollar (-10%), Canadian Dollar (-10%), or Mexican Peso (-10%), it’s easy to see that the U.S. dollar persists higher. The next big move will most likely be resultant from the BoJ and/or ECB’s October policy responses. Given immediate disinflationary pressure, will Kuroda be able to hold off additional easing until months end? Will the ECB be able to look the other way regarding a further slowdown in Europe? All that aside, it’s presently difficult to imagine a scenario that would place the U.S. dollar on its heels.