When the Fear Gauge of Wall Street Speaks

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Oh man, October isn’t proving much fun when it comes to the stock market. US shares had another volatile session overnight. The Dow fell over 500 points in early trade before recovering most of the losses.

Any day trader would have been whipsawed. The future looks as unclear and murky as it did yesterday.

But we do have a potential clue. We can analyse it in the logical spirit of Hercule Poirot or Sherlock Holmes.

It comes with the full knowledge we could end up looking more like Inspector Clouseau or Frank Drebbin.

It’s to do with the Volatility Index.

You might know it as the VIX or ‘fear gauge’ of Wall Street…

The VIX tracks volatility using index pricing. Here’s the basic equation: market down, VIX goes up.

Cast your mind back to the sharp drop in early February. The VIX hit a high of 50. That was its highest point since 2015.

Grab your magnifying glass and deerstalker hat. Here’s the clue worth noting.

The S&P 500 made a final low on February 9 before the market resumed its overall uptrend. The VIX, however, made a high in that time on February 6.

My dear Watson, don’t you see? The point is the VIX was settling down before the S&P 500 made its final bottom at 2,580 points.

A similar dynamic is playing out now. It’s good news if you’re long stocks.

As above, the US markets dropped sharply at the open in the session just gone.

Here’s the main point: The VIX didn’t spike above the high it set on 10 October. That’s when the market had its second panicky decline for the year (alongside February).

It suggests the market might be setting up for another rally like it did in February. But hold that thought: The market can turn on a dime. The VIX could spike tonight, for all I know.

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But, as of today, the worst of the October selling might be behind us.

My read is that US stocks are more than likely to tread water until after the midterm elections due next month in America. That’s an uncertain result, and markets go sideways under this condition, usually.

The most interesting angle on that right now is Trump’s proposed 10% tax cut for middle-income Americans. Don’t get me wrong: It might be no more substantial than many of the President’s brain farts.

But it does bring the US deficit into view.

One wonders how many Treasury bonds the US government can shove down the throat of the world before we get choking sounds…

Bonds set the tone for world markets

The US deficit was up 17% in the year ending on September 30. There’s no likelihood of it getting much smaller anytime soon. But the US might run into financial reality at some point.

The Fed is running down its bond portfolio. We knew that. Now, the Wall Street Journal reports that the share of foreign ownership of US Treasuries is in a long-term downtrend. In fact, it’s at the lowest point in 15 years.

Trump may find his trade moves have an unintended consequence: Reducing China’s trade balance means they can buy less Treasury bonds.

Some analysis I saw this morning also makes a useful point. We need to be watching Europe.

The ECB set to shake the world

Fixed-income investors there have been hunting all over the world for yield because the European Central Bank (ECB) pinned interest rates so low. The ECB has also been buying up a huge number of bonds, as well. That reduces their supply.

However, QE in Europe is due to end sooner rather than later. That means European fixed-income investors are likely to switch back to their home markets…and away from America.

That’s not all…

The market is beginning to price in rising interest rates in Europe, too. That’s driving up the cost to hedge the US dollar currency risk for foreign investors into the USA. It reduces the profit of holding US Treasuries.

This might all sound a bit obscure, but it indicates that yields are likely to stay under pressure (to rise) in the USA. Existing bonds fall in price when this happens.

All this, taken together, is driving up the appeal of US stocks, relative to the bond market. The earnings yield on the S&P 500 is still over 4%.

I’ve told you earlier that US stocks have been higher every following midterm election since 1946.

I believe underlying currents in the US bond market are going to push US stocks higher…and, if the history of markets is any guide, they’ll go way beyond what anyone currently imagines.

Regards,

Callum Newman Signature

Callum Newman,
Editor, Profit Watch

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