All in all, it has been a great couple of months for gold and the U.S. stock market. Who would have ever thought back in March that the S&P 500 would be back above 3,000, the Dow Jones Industrial Average would be back above 25,000 and the Nasdaq would be at a new all-time high in late June?
The bulls are definitely in control on Wall Street.
However, we’re seeing some telltale signs of worry that could signal a coming slowdown in U.S. equities as the number of confirmed coronavirus cases continues to surge across the country. Just yesterday, the Dow dropped more than 700 points on news of a record spike of COVID-19 cases.
It’s too early to call the top and the resumption of a bearish downtrend, but we’d be silly not to pay attention to the potential warning signs.
So, what’s happening? We’re seeing movement in three key indicators: gold, the VIX, and the VIX/VIX3M relative-strength chart.
Let’s start with gold.
Gold
Gold is one of the oldest safe-haven assets. Traders view gold as an excellent store of value because unlike national currencies, governments can’t just create more of it whenever they want to.
Of course, gold has its drawbacks as well. The biggest problem with gold is that it is a non-yielding asset. Gold doesn’t pay a dividend or generate earnings. It just sits there.
This is less of an issue, however, when Treasury yields are as low as they are now. When traders can’t find much yield, they’re less concerned about the opportunity cost of moving their money to a non-yielding asset like gold.
The value of gold is driven by demand. When demand is high, the value of gold goes up. When demand is low, the value of gold goes down.
Demand for gold has been increasing this month because traders are worried about the damage that could be done to the U.S. economy if states and cities reinstate or intensify their lockdown orders.
In fact, the price of gold is back above $1,500 per ounce (see Fig. 1).
Gold is now trading just below $1,800 per ounce. If you look at the weekly chart in Fig. 2, you will see that gold has climbed all the way back up to where it was trading in the aftermath of the 2008 Financial Crisis — when the precious metal topped out at $1,923.70 per ounce.
This tells us traders are continuing to load their portfolios with safe-haven assets just in case the stock market takes a turn for the worse.
Next, let’s look at the VIX.
The VIX
The CBOE S&P 500 Volatility Index (VIX) is known as the “fear index” because it is such a helpful gauge to measure how worried traders are that the S&P 500 might suddenly drop within the next 30 days.
When the VIX starts moving higher, it is telling you that traders are getting nervous. When the VIX starts moving lower, it is telling you that traders are gaining confidence.
Looking at the daily chart of the VIX in Fig. 3, you can see that the index has broken through the down-trending resistance level it had been interacting with since mid-April and is showing signs of turning around by forming higher highs and higher lows.
Seeing the VIX start to move higher tells us that traders are becoming increasingly worried about the potential of the S&P 500 dropping in the near-term.
Lastly, let’s look at the VIX/VIX3M relative-strength chart.
VIX/VIX3M Relative Strength Chart
Most traders tend to focus solely on the VIX, which is a measurement of the anticipated volatility being priced into S&P 500 options for the next 30 days, when they think about measuring trader sentiment.
However, as we’ve covered in the past, sometimes focusing only on the next 30 days isn’t a long enough view. Sometimes it is helpful to expand your horizons out to the next three months, or 90 days.
When traders need a longer-term outlook, they can look at the CBOE S&P 500 3-Month Volatility Index (VIX3M), which is a measurement of the anticipated volatility being priced into S&P 500 options for next 90 days.
By comparing the value of the VIX to the value of the VIX3M, you can identify periods when trader sentiment has turned extremely bearish and when it has normalized.
Because these volatility indexes measure the magnitude of the price movement traders believe the S&P 500 may make during the measured time frame, the value of the VIX3M is usually higher than the value of the VIX.
After all, if you give the market three months to make a move — like the VIX3M measures — instead of just one month — like the VIX measures — it has a greater chance of making a larger move.
Interestingly, there are times when traders will price in a greater chance of a larger move in the short-term than in the long-term because they are nervous the market is about to drop. This pushes the value of the VIX up higher than the value of the VIX3M.
The easiest way to compare the value of the VIX to the value of the VIX3M is to create a relative-strength chart of the indexes where you divide the value of the VIX by the value of the VIX3M.
Typically, the VIX/VIX3M relative-strength chart will have a value less than one because the value of the VIX is usually less than the value of the VIX3M.
During periods of high market stress, the VIX/VIX3M relative-strength chart will often have a value greater than one because traders are pushing the value of the VIX higher than the value of the VIX3M.
So, where is the VIX/VIX3M now?
According to Fig. 4, the VIX/VIX3M is flirting with one, meaning the VIX is starting to outpace the VIX3M.
The VIX/VIX3M closed above one on June 11 and has crossed above one four times since then during market hours.
This tells us bearish concern is becoming more acute.
The Bottom Line
The warning signs we’ve highlighted above are no more than potential red flags at this point. We’ve seen traders become concerned in the past only to see that concern fade away as more positive news has emerged.
We’ll be watching the news this next week for any signs that states and cities may start moving back toward stricter shelter-in-place policies because of the surging number of COVID-19 cases.
We’re also approaching second-quarter earnings season in a few weeks, which will provide a much-needed glimpse into the health of corporate America.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of Strategic Trader.
