3 reasons why volatility could come roaring back to a stock market that’s drifting along near record highs, according to UBS

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  • A key tracker of stock-market volatility at its lowest since early 2020 at the same time that US stocks are at record highs.
  • Investors should anticipate Wall Street’s so-called “fear gauge”, or VIX, to come off those lows in the coming months, said UBS.
  • Volatility may pick up pace as investors wrestle with inflation worries and COVID-19 variants.
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Wall Street’s key measure of stock-market volatility is at its lowest since the COVID-19 crisis took off in the US last year, but that calmness will likely break over the next few months, according to UBS.

The US stock market has soared to record highs in 2021 on the back of accelerating coronavirus vaccinations worldwide and roughly $5 trillion in financial aid deployed by the US government to mitigate the pandemic’s economic damage. The vaccinations and stimulus packages have been laying the groundwork for a further reopening of the world’s largest economy as people begin to rebuild work and school routines and spend the money sent to them by Uncle Sam.

The S&P 500 index has shot above the 4,100 level and the Dow Jones Industrial Average tracking blue-chips is at its strongest levels, driven by cyclical sectors such as energy and industrials that stand to benefit from increased economic activity.

Wall Street’s so-called “fear gauge,” at the same time, has dropped below the 17 level, the lowest since early February 2020, before the World Health Organization declared the coronavirus outbreak a pandemic. But don’t expect the Cboe volatility index to continue to stay that low, said the world’s largest wealth manager in a note published Friday.

UBS noted a news report that at least one investor bought about $40 million in VIX call options that indicate the buyer expects market volatility to pick up pace over the next three months. One or more investors anticipated the VIX to reach above the 25 level and rise towards 40 by mid-July, Reuters reported, citing trading data.

“We see reasons to expect periodic bouts of higher volatility in the near term,” said Mark Haefele, chief investment officer at UBS Global Wealth Management, in the note.

Growth vs inflation

Firstly, investors may be torn between optimism over accelerating economic growth and worries over higher inflation. Among the signs that recovery is taking further hold was the recent and strongest reading in services-sector activity since 1997 from the Institute for Supply Management. European growth should also strengthen as vaccinations increase.

“Still, as pent-up demand meets supply constraints, a pickup in inflation could well unsettle investors,” said the investment bank. This week, Dallas Federal Reserve President Robert Kaplan said inflation could rise “well in excess of 2.5%,” over the summer, which would be well above the Fed’s 2% target.

COVID-19 strains

Investors have so far looked through news about variant strains of COVID-19. “This optimism could be put to the test by the spread of new variants of the virus, especially in areas where the vaccination effort has been progressing well, such as in the US.”

UBS noted “pockets” of rising infections in Ohio and Wisconsin.

Trading activity

Volatility has been “sporadically heightened” by a rise in institutional and retail activity in the options market, along with the increased share of growth stocks in major equity indexes, said UBS.

“In the first quarter we saw retail activity driving volatility in individual stocks, such as GameStop, which spilled over into broader market swings,” said Haefele.

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The stock market’s fear index just dropped below a key level that suggests further upside ahead

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  • A decline in stock market volatility over the past few weeks suggests more upside ahead for stocks.
  • On Tuesday, the CBOE Volatility Index fell below the key 20 level and hit its lowest levels since the start of the COVID-19 pandemic.
  • According to Fairlead Strategies’ Katie Stockton, a consistent VIX reading below 20 would signal a bullish shift in sentiment.
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The stock market’s fear gauge fell below a key level on Tuesday that suggests further upside ahead for stocks.

The CBOE Volatility Index, also known as the VIX, fell below the 20 level and hit its lowest point since the start of the COVID-19 pandemic. A VIX below 20 is seen as a signal that the stock market is transitioning from a high volatility regime to a low volatility regime, according to Fairlead Strategies’ Katie Stockton.

And according to Fundstrat’s Tom Lee, a fall below 20 in the VIX signals a risk-on environment that would spark fund flows into stocks from systematic and quantitative investment funds.

“A fall below 20 takes this volatility index to pre-2020 levels and a drop in the VIX would be a risk-on signal,” Lee said in a note last month.

But the VIX has staged multiple head fakes over the past few months, briefly falling below 20 before spiking higher in February, November and August.

That’s why Stockton recommends investors wait for confirmation of a breakdown in the VIX before making any portfolio changes, like removing market hedges. Confirmation of a VIX breakdown would require consecutive daily closes below the 20 level, according to a Tuesday note from Stockton.

“This would mark a potentially bullish shift in sentiment, and a move from a high-volatility regime to a low-volatility regime, last seen pre-Covid with a new floor for the VIX near 11,” Stockton said, adding that a VIX breakdown “would support near-term upside follow-through for the inversely correlated S&P 500.”

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Wall Street’s favorite volatility index is the latest stock-market bubble, JPMorgan’s quant guru says

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  • The Cboe Volatility index – or VIX, commonly known as the stock market’s fear gauge – is the latest bubble to form, JPMorgan’s Marko Kolanovic said.
  • The forward-looking gauge of expected price swings currently trades with an 18-point spread to S&P 500 realized volatility, a historically high reading.
  • Precedent suggests the gap will lead to weaker volatility and rising stock prices, Kolanovic said.
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The latest bubble in the stock market isn’t a stock at all, but Wall Street’s favorite volatility metric, Marko Kolanovic, global head of macro quantitative and derivatives strategy at JPMorgan, said Wednesday.

Stocks’ climb to record highs earlier in February triggered speculation around whether some sectors had grown overstretched. Elation over tech stocks, SPACs, and cryptocurrencies all prompted calls that the market was rife with bubbles.

Such concerns are largely overblown, Kolanovic said in a note to clients. The FANG coalition – Facebook, Apple, Netflix, and Google-parent Alphabet – has mostly traded flat for six months despite recovery optimism. The energy and financial names that have ticked higher in recent sessions still trade well below record highs.

However, the Cboe Volatility Index – or VIX, which is a reading of 30-day expected stock volatility – sits squarely in bubble territory, the quant expert said. The index provides an implied reading of future S&P 500 price swings calculated from options contracts. Yet the VIX is now decoupled from S&P 500’s underlying volatility, “indicating a bubble of fear and demand from investors looking to hedge or profit” from a potential sell-off, Kolanovic said.

The so-called fear gauge currently trades at a roughly 18-point spread with S&P 500’s two-week realized volatility, according to JPMorgan. That gap is in the 99.6 percentile over the past three decades, implying a historic disconnect between the VIX and the volatility it’s meant to measure.

Such instances typically happen after massive shocks in the VIX and give way to a decline in volatility, Kolanovic said. Historical data also suggests the S&P 500 will rise as the volatility index course-corrects, he added.

JPMorgan recommended investors sell the “VIX bubble” until such a correction takes place. The potential for new fiscal stimulus and ultra-loose monetary conditions make for strong macro fundamentals, and falling daily case counts suggest the US can soon recover from the pandemic. Additionally, the rotation from growth to value stocks is keeping the correlation between stocks low. While some continue to warn of growing risk in the market, funds are piling into stocks as price swings moderate, Kolanovic said.

“Low volatility drives inflows, triggering a positive feedback loop of a rising market and declining volatility,” he added.

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