Up the stairs, down the lift

Increased volatility goes hand in hand with spikes and corrections

The sharp sell-off on global equity markets in October was rather brutal. It was the second such selloff of the year. The first happened in January and February, making for a volatile first quarter. The second and third quarters were calmer for equity markets, as can be seen in the chart of the S&P 500.

The start of the fourth quarter saw another sharp correction, equal in magnitude to the drop-off in the first quarter.

Both corrections in Q1 and Q4 were about 10% in magnitude. Both were quick and aggressive. The saying “The bull climbs up the stairs and the bear goes down the elevator” was true in both these corrections.

What is notable about the most recent 10% correction is that it has left more technical damage in its wake. The upward trend that was evident through 2016, 2017 and most of 2018 has been broken to the downside.

When technical damage of this significance occurs, it is worth paying attention to as it indicates that the typical strategy of buying every dip in a rising trend is no longer valid. Buyers are no longer as dominant as they were and sellers have arrived to spoil the party.

In the case of the S&P 500, the break below the uptrend at 2,800 saw further selling pressure all the way down to 2,600. That lateral support level has held and was met with buying pressure in mid-October. A bounce has subsequently unfolded in the recent weeks to re-test the underside of the prior uptrend line at 2,800. Whether this will be a “goodbye kiss” before another leg lower remains to be seen.

Whatever the outcome, it is clear that at best the upward trajectory of the world’s largest equity index has begun to slow. At worst it has begun a process of rolling over and marking the peak of a mature bull market.

With fundamental risks rising, this technical picture ties in to a view that suggests some tempering of return expectations in the year(s) ahead.

Along with the two 10% corrections, we have seen inevitably higher volatility. This is measured by the Chicago Board Options Exchange volatility index (VIX). It is a measure of the volatility that options traders use to price options on the S&P 500. The VIX is often referred to as Wall Street’s “fear gauge”. High volatility is associated with greater uncertainty, so traders are willing to pay a higher price for options protection. The opposite occurs when markets are calm and volatility is lower.

Spikes in the VIX can be clearly seen in 2018: one in January and February, and another in October. Unsurprisingly, these spikes in volatility occurred when each of the 10% corrections happened on the S&P 500. What is also notable is that the generalised level of the VIX has been higher during 2018 than it was during 2017 and 2016 when the S&P 500 was trending higher. High and rising levels of volatility at this point in time are notable.

Along with the technical damage that has occurred on the S&P 500 and the fundamental risks that continue to build, it appears markets are showing signs of increased nervousness. This is not uncommon in the final stages of a bull market.