The following is a guest post courtesy of Michael Kramer of Mott Capital Management.
As uncertainty ticks higher in markets, volatility tends to follow. There is a tremendous amount of doubt building in the equity markets, especially regarding corporate earnings. With the market on the cusp of earnings season, volatility may see a massive spike.
The VIX index may be ready to break higher, based on options positioning, which the SpotGamma Equity Hub model shows, as discussed later on. Additionally, trends display that the VIX index tends to spike when ambiguity around earnings increases, significantly decreasing the market. It may only take a jump above 25 on the VIX to push the stock market materially lower.
Rising Uncertainty
An easy way to measure the uncertainty built into earnings estimates is to look at the standard deviation of analysts’ consensus forecasts. The lower the standard deviation, the more confidence an investor can have towards those estimates. More recently, the standard deviation has been rising, indicating increasing risks in those forecasts.
Historically, the VIX and standard deviation in earnings estimates have been highly correlated, moving higher or lower together. It makes sense for this correlation to exist since earnings and growth rates are the most basic components of what drives stocks and markets higher or lower. If investors have good visibility into earnings, they are likely to be more confident in buying stocks. When visibility is not as strong, they are less sure about owning stocks, thus reducing valuations and increasing volatility.
Since February, the opposite has been happening, with the standard deviation rising and the VIX moving lower, creating a considerable divergence. The last time there was a significant variation like this was in 2018. That, of course, led to a significant spike in volatility in the fourth quarter of that year. Not all that different from what we are now starting to witness in the fall of 2021. Given this divergence and its potential close, one would expect the VIX to spike higher… and soon.
A VIX Spike to Come?
It seems reasonable to think that the VIX index should spike higher from here. The SpotGamma Equity Hub shows a healthy amount of Call Gamma built into the market, and a significant spike in the VIX would result in market makers needing to buy VIX futures on a VIX spike. It, of course, could send the VIX index very high as market makers look to hedge their positions.
The model also shows there is a level of support around 20 on the VIX, and it appears to be confirmed by how the VIX has been trading recently, with the critical level of support between 20 and 21 since September 28 seen on technical charts. Combining Equity Hub’s data with the technical charts, it would seem that once the VIX breaks above 25, there is a very good chance there could be a massive uptick in volatility, which could be an enormous force, sending the equity market significantly lower.
The recent volatility in the market seems it may only be starting, and not without reason. There is a growing amount of anxiety being built into the market, and it seems that the outlook for earnings may be an underlying concern. It appears that investors have just been slow to catch on, and that may make any decline in the market based on the options positioning of the VIX very fast and sudden.