The S&P 500 Index is soaring to record highs as market volatility is at its lowest level in over four years. Historically, spikes in volatility have often signaled significant drawdowns in the S&P 500. But today’s market has been quite resilient as the VIX has seen a strong downward trend. In this article, we aim to help individual investors understand market volatility and its historical context. The article also dives into the state of the US economy and market breadth concerns.
Historical Context: Low Volatility Periods
Today’s low level of stock market volatility is reminiscent of some of the most stable periods over the past three decades, such as the early 1990s, early 2000s, and the years between 2013 and 2019. These periods of calm have typically coincided with robust economic performance. However, the current scenario is different, with clear signs that the US economy is beginning to show cracks.
Rising Consumer Delinquencies and Volatility
One significant indicator of economic stress is the rise in consumer delinquencies. Over the last year, delinquencies in the US have surged to their highest levels since the financial crisis. Historically, variations in consumer delinquencies have been closely correlated with stock market volatility. Rising delinquencies generally indicate a weakening economy, increasing uncertainty among investors and driving up market volatility. Conversely, falling delinquencies often correspond to periods of low market volatility.
Today, this historical relationship appears to have broken down. Despite a significant rise in delinquencies over the past couple of years, market volatility has declined since 2022. However, this divergence may not last long. To understand why we need to delve into the role of the Federal Reserve.
The Federal Reserve’s Influence
The Federal Reserve controls the “price of money” by adjusting the federal funds rate, which is the interest rate at which banks lend to each other. By increasing this rate, the Fed can limit borrowing and slow the economy, often leading to recessions. Conversely, reducing the rate encourages borrowing and stimulates economic growth.
Connecting the Dots: Volatility and Interest Rates
If we overlay the S&P 500 volatility index with the federal funds rate, an immediate impact isn’t apparent. However, by shifting the interest rate data forward slightly, a strong correlation emerges. This indicates a lag between the Fed’s actions and their effects on the economy and financial markets.
Academic research supports this thesis. A paper from the Bank of International Settlements shows that the negative impact of monetary policy on economic growth is most pronounced between the 6th and 9th quarters following interest rate hikes, which is an 18-month lag period.
Applying this lag to our current situation suggests that market volatility will bottom out between now and October 2024, with a potential spike to elevated levels. The key question is whether this will occur sooner or closer to October.
Market Breadth Concerns
Despite these projections, the S&P 500 remains bullish, trading near all-time highs with all key moving averages pointing upwards. This doesn’t indicate an imminent spike in volatility.
However, one concern is the small number of stocks driving the S&P 500 higher. Since January 2024, the number of participating stocks has steadily declined. This can be seen through the percentage of stocks above their 50-day moving average, which has been trending lower.
Less than 50% of stocks are trending up, even as the overall market climbs. This mirrors a similar pattern from 2023, where market breadth declined from January to May, yet the S&P 500 continued to rise. Eventually, this ended in a significant breakout, with broader participation and a substantial rally in the S&P 500. So, although the low number of stocks participating in this rally is concerning and does make the S&P 500 look less healthy and more vulnerable, it’s also possible that market breath can recover here and lead the S&P 500 for another leg up.
Conclusion
Despite the S&P 500 reaching record highs and experiencing the lowest volatility in over four years, consumer delinquencies in the US have surged to levels not seen since the financial crisis, breaking the usual correlation between rising delinquencies and increased market volatility. The relationship between the Federal Reserve’s interest rate adjustments and market volatility shows a strong correlation with an 18-month lag, suggesting that the current low volatility may soon reverse, potentially spiking between now and October 2024. Although the S&P 500 remains bullish and near all-time highs, less than 50% of stocks are participating in this rally, reflecting concerns about market breadth. This narrow participation mirrors patterns from 2023, where market breadth initially declined but eventually led to a broader breakout and further gains for the S&P 500, indicating a potential for recovery and another market uptrend. Click here to sign up! Subscribe to our YouTube channel and Follow us on Twitter for more updates!
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