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Stock market volatility has been relatively low, lulling investors into a sense of security. Does this complacency signal that the next drop in stock market prices is approaching? The Chicago Board of Options Exchange (CBOE) created and tracks the Volatility Index, more commonly known as the VIX. It is also referred to as the “Fear Index.” Let’s not get bogged down in its construction, but it considers options prices to represent investors’ expectations for the S&P 500 Index over the next 30 days.
The VIX is often used as a contrarian indicator. When the VIX is high, around 40, volatility is high, and people are panicky. The VIX will spike higher as fearful investors scramble to buy options as a form of insurance. Conversely, the VIX tracks lower, below 20, when investors feel the coast is clear. The VIX is predictive in so much that it follows the zeitgeist of the investment crowd. And when it comes to investing, the crowd is often wrong at extremes. The VIX closed as low as 16.78 on Tuesday, April 18, 2023.
Some bullish professional investors dismiss the low VIX as a reliable contrarian indicator. They profess that it’s different this time. These bulls maintain their bullish narrative by citing the surge in zero-day-to-expiration options (ZDTEO), which are contracts that expire the same day they’re traded. The VIX measures volatility 30 days out; market bulls contend that more and more investors are using these tools instead of the longer-dated options tracked by the VIX to hedge risk. It is argued that this suppresses the VIX level.
I have a different perspective—don’t worry about it just yet. I downloaded the daily close of the VIX for the last 20 years; the average was 19.27229. The VIX around 17 foretells a five- to 10-percent pullback but not a crash. I’ll keep an eye on it for you, but I am not overly worried about a VIX that isn’t far below average.
If you are a stock market bull, you have a better story to tell than a broken VIX. Jobs remain plentiful. Gross Domestic Product remains positive. Inflation is falling. The net profit margin for the S&P 500 was about 11.4 percent for the fourth quarter of 2022 (off its peak but equal to its 5-year average and pre-pandemic levels). Valuations could be better, but they’re not bad. The forward 12-month price-to-earnings (P/E) ratio for the S&P 500 is 18.3. That is near its 5-year and 10-year averages of 18.5 and 17.3.
But it’s not all rosy. On the opposite side of the ledger, banks remain a risk. Not that there appears to be an imminent run on banks. After a month of deposit declines at banks following the collapse of Silicon Valley Bank, deposits increased by $61 billion for the week ending April 5, 2023. That includes an increase of $23.5 billion at small banks, considered to be the most at risk. And even if a run on banks did occur, the government has shown that they are prepared to backstop even non-systemically important banks.
However, banks remain nervous. Bank credit has tightened considerably since March 15, 2023 (although it did loosen for the week ending April 5, 2023). It would be naive to expect banks to be as liberal with their loans as they had been, especially with regulators in the spotlight after missing factors that allowed banks to fail. During a CNBC interview on April 11, 2023, Pierre-Olivier Gourinchas, chief economist at the International Monetary Fund, cited a severe downside growth risk from bank lending tightening. Of course, that might be moot, given that consumers and businesses are less willing to borrow when capital costs are higher. Also, households and corporations will become cautious with their buying and investing given the year-long parade of headlines and pundits prognosticating a recession around the corner.
Many American shoppers are already pulling back on purchases of vehicles, furniture, and appliances. Consumers reduced their retail spending in March 2023 for the second month in a row. Purchases declined by one percent in March 2023 from the prior month.
Manufacturing also declined in March 2023. The number of job openings fell in the same month. And 23 percent of businesses decreased spending for the three months ending March 10, 2023 (nearly twice the share of firms compared to the prior year).
Here’s a typical chronological flow of recessions: First, the stock market prices in an economic downturn; then corporate earnings decline; and then the recession comes.
I’d argue that the October 2022 lows for the stock market sufficiently priced in a recession. It is possible that those lows could be revisited, but the good news is that the potential damage to the tape seems known.
Corporate earnings for S&P 500 companies are expected to be down for the first quarter of 2023 and the next quarter, making it three consecutive earnings declines.
Then, an NBER-defined recession could be triggered as early as late-2023, but more likely 2024 (if one even occurs).
If that flow tracks this time, it is reasonable that the S&P 500 tops out somewhere between current levels (about 4,200 points) to four percent higher before it drops eight to 10 percent (to about 3,7000 to 3,800 points). Let me be clear about that: I expect another 10-percent stock market correction in 2023. I won’t enjoy it, but that would occur as 1) stock prices already priced in a recession, 2) inflation is being tamed, 3) corporate earnings stabilized and are moving up, and 4) the Fed is no longer raising interest rates.
I will hate grinding 10 percent lower in 2023, especially after a miserable 2022. But if we do, I’ll shift from my hedged investment positions to something more closely correlated to an economic and market recovery.
Allen Harris is the owner of Berkshire Money Management in Dalton, Mass., managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
