The third quarter ends this month, and expectations seem to match the early earnings results that have already been released. There have been a few trouble spots, such as Sonos (NASDAQ:SONO), which dropped back to its IPO price following earnings, but the positive stock surprises are still running ahead of the disappointments.
One of the most important bellwethers each earnings season is FedEx (NYSE:FDX), which reported yesterday. FDX stock missed on earnings but beat on revenue and is down this morning after the news. However, we may need to wait a few days to see how the market truly feels about FDX stock, after the knee-jerk reaction is over.
In the meantime, there are other measures we can use to try and evaluate risk in the market and the potential for more near-term upside. If investors are nervous or expecting volatility, it should show up in option prices, which are reflected in the CBOE Volatility Index (INDEXCBOE:VIX). Although the outlook for earnings is still very positive, there has been some recent weakness expressed in the VIX that should be watched closely.
What the VIX Tells Us
The VIX rises when fear of volatility in the large-cap S&P 500 Index is on the rise (or the market is falling), and the VIX declines when investors are more confident and the major index is rising. Therefore, the lows in the VIX should correspond with highs in the S&P 500, because that is what we would expect when investors are confident.
As you can see in the next chart, the VIX’s lows in August match the highs in the S&P 500, except in one respect: when the VIX fell in the last week of August, it formed higher lows. If this were a perfect match to the S&P 500, we would have expected it to make lower highs. In this case, investors were a little less confident (as shown in the higher lows in the VIX) at the new highs in the S&P 500. That is typically a bad sign.
We saw this same signal in January of this year, just before the collapse in the SPX in February. That instance led to an above-average correction, but the VIX/SPX “divergence” provided an accurate warning. The question at this point is whether the correction we would expect from a signal like this is already over with the Aug. 30 – Sept. 7 decline or if there is more to come. We are inclined to think that this one is played out, but it is still a reason to be extra careful in the current market.
Part of the reason we aren’t as concerned about this VIX signal as we were in January is that there aren’t any confirming volatility indicators. The SKEW index is fairly flat, and the Russell 2000 VIX did not also form a divergence. When both the large-cap VIX and Russell Small-Cap VIX signal divergences, then the probability for a larger decline is much higher. You can see an example of matching signals between the VIX and the RVX that appeared in January in the following chart.
The Bottom Line
Expectations for market volatility are a little higher than we would like to see before earnings season. This does increase the potential risk in the market, but it also increases the odds for large moves, which should be good for long option traders. From a longer-term, strategic perspective, we plan to increase a little of our bearish exposure and make sure we are taking advantage of opportunities to hedge our bullish trades.
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