What’s Going On with the ‘VIX?’

There are a lot of indicators to watch in the market. There are moving averages, price-to-earnings ratios, relative strength ratings, earnings per share (EPS) growth rates, stochastics, Bollinger bands — and even something called a Fibonacci. 

While most market indicators are useful in their context, sometimes there are indicators that give off a perplexing warning sign that becomes an interesting metric to track during a potential market pivot. Today, that indicator is the market dynamic that is the historical inverse correlation between the broader stock market (S&P 500 Index) and the CBOE Volatility Index (VIX). 

The following analysis of the VIX appeared Tuesday morning in the inbox of subscribers to my Eagle Eye Opener daily market briefing. Here, my “secret market insider” provided us with this deep dive into what the VIX is telling us right now. So, if you want this kind of insight sent to you each morning at 8 a.m. Eastern, then you must subscribe to Eagle Eye Opener today!

Since markets bottomed in March 2009, the S&P 500 and the VIX have consistently maintained an inverse correlation, with the volatility index typically drifting steadily lower as equities powered to new highs (think 2017, when the VIX fell into single digits amid steady stock market gains) while bouts of volatility and short-lived selloffs in the stock market saw the VIX spike higher. Digging into this relationship deeper, when stocks made new meaningful lows below notable support levels, the VIX would almost always rise to new highs beyond those that corresponded with the previous lows in stocks. 

For example, as the S&P 500 dropped below the lows from late 2018 (2,346) during the Q1 ’20 COVID-19-crash, which carried the index down to 2,191, the VIX blasted through the late-2018 high of 36.20 and peaked at a staggering 85.47. The uncertainty associated with the first pandemic in 100 years certainly amplified the move higher in the VIX in that example, but it does illustrate the point of the traditional inverse correlation between stocks and the VIX very well. 

Now, the actual formula and process used to calculate the VIX is very complex and involves some high-level math, but in the simplest terms, the index measures price activity, mainly demand, in the options market. That is why in normal market conditions, the VIX rises amid increasing demand for puts as the broader stock market declines, and this also the reason it is often referred to as the markets “fear gauge.” 

So, when “smart money” is adding hedges to long equity positions in an attempt to limit drawdowns and reduce portfolio risk, the VIX rises with the increasing demand in the options market. This occurs regularly during periods of volatility in secular bull markets, as investors prefer to avoid selling positions outright for tax reasons. 

In normal bull markets, new lows in the S&P 500 are almost always met with new highs in the VIX (with a few outlier exceptions such as the “VIX-mageddon” event in early 2018). As the market recovers and smart money reduces those hedges, the VIX tends to retreat, often quite rapidly.

But at both of the most recent major market peaks that occurred in 2000 and then again in 2007/2008, that historically consistent inverse correlation between the stock market and the VIX broke down as new meaningful lows in the S&P 500 were not met with new highs in the VIX. And it has happened again this year. 

The logical question to ask here is: why would this happen?

At first glance, it makes no sense as to why a widely followed, broad-market volatility indicator would just suddenly stop functioning as it has for the last decade. However, as we have noted over the course of the year, there is a likely explanation for making sense of a breakdown in the relationship between the S&P 500 and the VIX. 

As stocks make new meaningful lows, as they first did in February, then again in May and June of this year, we believe sophisticated investors were actually liquidating long-term, long equity positions as opposed to holding those positions and just adding hedges to manage risk and downside exposure as was discussed above. When there is “real” selling and liquidation going on by sophisticated investors, most of them are also unwinding hedges, which, in its simplest form, means the net selling of put protection (although some hedging strategies are very complex and go well beyond simply holding single strike puts) and therefore keeping pressure on the VIX per its complex calculation of demand for options. 

So, what we are seeing in cross-asset analysis with the VIX and the S&P 500 right now is the same thing we saw in both 2000/2001 and 2007/2008 in the early stages of those respective bear markets. And the bad news is that this dynamic only persists during the “distribution phase” of market cycles when sophisticated investors are liquidating to retail investors attempting to “buy one more dip.” Once the VIX finally breaks the downtrend of “lower highs” and begins to move meaningfully higher, the real breakdown and capitulation in stocks begins. 

Looking at the dot-com bubble, the downtrend in the VIX was broken in September 2001, and the S&P 500 proceeded to decline another 30% or so, as the VIX ripped higher, before finally bottoming in late 2002. During the financial crisis, the VIX downtrend was not broken until September 2008, and the S&P 500 fell another 47% to the March 2009 lows (of course, the VIX ripped higher as well). 

Fast-forward to 2022 and once again, September saw the VIX break through multiple significant downtrend lines, suggesting we may be on the cusp of the final capitulation phase of this bear market cycle. There is no way to confidently forecast how far stocks could fall from current levels, but using the last two major bear markets as a guide suggests that additional losses could be significant. 

On the charts, now that the longstanding downtrends in the VIX have been broken, the critical level to watch is the June high of 35.05. A break above there would very likely signal significant pain (borrowing the term from Federal Reserve Chairman Powell) looming in the equity markets. 

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ETF Talk: Gain Inverse Exposure With This Short ETF

To paraphrase Thomas Paine’s famous pamphlet, “The Crisis,” “These are the times that try investors’ souls.”

Indeed, while some recent days have been bright spots in an otherwise bleak market landscape, Forbes reported that the S&P 500 was down nearly 24% on the year through Sept. 30, and even reached its lowest level since November 2020. It is clear that the bears are still free to rampage across the market landscape.

The causes of this market devastation are what I frequently discuss in my newsletters and “Eagle Eye Opener” — a hawkish Fed ensuring ever-higher interest rates, COVID-19 lockdowns in China, rising oil and energy prices and the continuation of the war between Ukraine and Russia in Eastern Europe. Even though we are in an environment in which nearly every sector is in the red, all is not lost.

One way to generate profits during periods when the market is down is through the exchange-traded fund (ETF) ProShares Short QQQ ETF (NYSEARCA: PSQ). As its title suggests, this is an inverse ETF, meaning that it is built to go up in value when its parent index goes down.

Specifically, PSQ provides inverse exposure to a market-cap weighted index of the 100 largest firms on the NASDAQ index that are not financial companies. The fund’s managers then use swaps on the NASDAQ-100 ETF (QQQ), swaps on the index itself and NASDAQ-100 futures in order to provide the stated exposure.

At the same time, it is worth noting that this ETF, like its fellow inverse ETFs, is meant to provide its stated exposure each day. Investors who view it as a buy-and-hold investment will likely see irregular returns over a longer time.

As of Oct. 11, PSQ has been up 15.86% in the past month and up 8.31% for the past three months. It is currently up 39.61% year to date.

Chart courtesy of www.stockcharts.com

The fund has amassed $1.70 billion in assets under management and has an expense ratio of 0.95%.

In short, while PSQ does provide an investor with a way to invest in an inverse ETF, this kind of fund may not be appropriate for all portfolios. Thus, interested investors always should conduct their due diligence and decide whether the fund is suitable for their investing goals.

As always, I am happy to answer any of your questions about ETFs, so do not hesitate to send me an email. You just may see your question answered in a future ETF Talk.

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Wednesdays Mean Wisdom 

Did you know that Wednesday means wisdom? 

Well, not technically speaking, but Wednesdays do mean a fresh dose of wisdom from some of the greatest thinkers the world has ever known, as those thoughts are profiled each Wednesday on my podcast and lifestyle website, Way of the Renaissance Man.

This week’s wisdom is all about harnessing passion, and who better to remind us of how to do that than American novelist, poet, and one of the pioneers of the Beat Generation, Jack Kerouac.

If you want a little dose of inspiration (and who doesn’t?), then check out the newly published Wednesday Wisdom featured right now at Way of the Renaissance Man.

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In case you missed it…

Behold the Power of Effective Communication  

Note: Today I am proud to present to you a guest editorial by my friend and colleague Heather Wagenhals. An expert in communications, media and public speaking, Heather’s insights into how to effectively communicate are a perfect antidote for our polarized, tribalistic times. If you want to learn how to be a more effective communicator and to effectively persuade others, this article is for you.

“To disagree, one doesn’t have to be disagreeable.”

These words were spoken by my home-state Senator and the 1964 Republican nominee for president, Barry Goldwater. Sadly, today the idea of disagreeing without being disagreeable is barely recognizable in the public square. These days, extremism is the norm. Forget about terms such as “liberal” and “conservative” or “knuckle dragger” and “snowflake.” Those terms are much too docile.

Now, you are a “masker” or an “anti-masker”, a “Karen” or a “virtue-signaling, knee-taking apologist.” Even within my own Republican party, the rhetoric has become toxic. These days you are either a conspiracy-spreading QAnon disciple, or you’re a “RINO,” or a “Republican In Name Only.”

This labeling and name-calling, including those now-infamous tweets sent from the highest political office in the country, coupled with the lack of respect for our fellow human and the vitriol cast at those who disagree have fomented a pernicious intolerance that we haven’t seen in this country in decades. All one needs to do is look at the disgraceful Capitol siege that took place on Jan. 6 to know this.

To me, this heinous behavior demands action, because if you are like me, a liberty-loving American who wants the best for their country, it is incumbent upon you to find and create connections with those who are still reasonable in order to make our country better.

You see, in today’s soundbite-fed, personalized social-media-streaming era, we can get lost in our own custom-tailored, perfectly curated and dreadfully myopic world. By avoiding reality through avoiding other perspectives and engaging in effective dialogue with others, we are only doing ourselves a major disservice.

As my friend and editor of this publication, Jim Woods, has written, “The only solution to bad ideas is good ideas.” Well, my corollary to that is that “The only way to put good ideas out into the world is to effectively communicate those ideas, and especially to those who might initially disagree.”

Sadly, today the art of communication seems to have been lost. In a digital age of texting, email, direct messaging via social media apps and 280-character tweets, we seem to have lost our ability to create meaningful connections and to employ all our communication faculties to effectively persuade others.

Yet I believe there is still time to reach the undecided.

I am of the opinion that there are those who might ardently disagree with my views but who also are still open-minded enough to be willing to be persuaded. I know this because I have this mindset, and the chief reason why is because I don’t want to be wrong in my thinking. And if I can be persuaded by a strong and effective argument, one with facts, logic and emotional content, then so can others.

Of course, the trick becomes: how does one do this? Here again, I’ll turn to Jim’s insights, as he recently wrote, “In order to persuade others, we first must avoid putting them on the defensive with disrespect and insult. If you can do that, you’re already halfway home.”

One way to avoid putting others on the defensive is to understand what’s happening to them when you do just that. Indeed, knowledge of how we think and process information, and how our biology affects us when we greet and interact with other people, will help us succeed in effectively persuading others.

For example, if I had started this article with racial slurs and misogynistic insults and man-hating statements, you’d probably get angry with me from the outset. In fact, the minute you or someone you feel a kinship with is attacked, your survival instincts kick in and you’ll shut down the critical thinking areas of your brain and stop listening.

So, the first thing we must learn to do is avoid “pressing another’s buttons.” If you immediately start hurling labels at others such as “liberal” or “leftist” or “woke progressive,” you aren’t going to be able to unlock the key to persuasion.

Instead, why not just begin a conversation with a sincere attempt to understand why a person thinks the way they do, and what their reasons are for those thoughts? Indeed, sometimes just the simple power of asking questions can be the most effective form of communication and persuasion.

Think of it as the Socratic method, or what’s sometimes referred to as “street epistemology.” The power of asking poignant questions to others, and their own realization that they may hold views without very good reasons, can be a profound tool for initiating change. And you do so without you ever having to pass judgment.

The second thing we can do to help promote better conversations is to assume responsibility for ourselves. In this context, that means understanding that effective communication is 100% your responsibility — not to get your point across, but rather, to elicit the right result. Let me explain.

Have you ever asked anybody to, “meet me halfway” in a negotiation? If two people are involved in communication or negotiation, what do you think the percentage should be? Is it 50/50? Is it 60/40?

The answer is it’s 100% your responsibility because that’s the only person you have control over. Here, it is important to consider that the meaning of a communication is all about the response you elicit. So, if you’re not able to persuade others, it’s you who haven’t communicated effectively.

The next time you approach a discussion of any kind, instead of pushing your ideas onto others and exacting your will, try to show them a path and lead them to a better way of thinking. And instead of pushing, try persuading via sincere interest and curiosity in what they believe in.

Finally, remember that great communication and effective persuasion is not about you. It’s all about the other person. So, it’s not about how fabulous or sophisticated or smart you are, it’s about figuring out the right things to say or the right questions to ask the other person. In other words, force your interlocutor to confront and explain their beliefs. You’ll be surprised how disjointed and how unstable many deeply held beliefs really are.

Once you’ve helped another realize this, the pump is primed for a deeper conversation about what you think, and how you think your ideas can improve things for everyone.

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On Being Interesting 

“Show me a man who’s not interested in the world, and I’ll show you a man who’s not very interesting.”

— Jim Woods 

This week’s quote comes from a familiar source: me! This maxim came to me as I was speaking with a friend about the importance of cultivating an interest in a wide variety of subjects. I told him that the key to being a Renaissance Man was to be truly interested in a lot of things. And by cultivating an interest, you learn. And by learning, you also become a person that others find interesting. So, if you want to be interesting, be interested in the world. Besides, being curious and learning is the most fun thing a human can do. 

Wisdom about money, investing and life can be found anywhere. If you have a good quote that you’d like me to share with your fellow readers, send it to me, along with any comments, questions and suggestions you have about my newsletters, seminars or anything else. Click here to ask Jim.