The S&P 500 broke out of a bear market on Thursday, while a closely watched gauge of stock market volatility fell to a more than three-year low. These two things are related, says Tom Lee, founder of Fundstrat Global Advisors.
The Cboe VIX Volatility Index,
an options-derived measure of the S&P 500’s expected volatility over the next 30 days, traded as low as 13.50 on Friday, its lowest since February 2020. The gauge’s long-term average is near 19. A moderate reading indicates that investors are feeling optimistic. . The VIX averaged 25 in 2022, while the S&P 500 posted a 19.4% decline.
“The impact of the VIX is the least appreciated. Our December 2022 work shows that in the last 30 years, the post-negative equity year (2022), when the VIX has fallen [year-over-year]the average gain is 22%,” Lee said in a Friday morning note to clients (see chart below).
The role of the VIX is bigger than the impact of movements in the US dollar, earnings per share or even bond yields, Lee said.
“The VIX trajectory, in other words, was the main driver in early 2023. That appears to be playing out today,” he wrote.
The S&P 500 SPX,
rose 0.2% late Friday afternoon to trade just above 4,300. It closed at 4,293.93 on Thursday, its highest close since August 16. It also finished more than 20% above its Oct. 12, 2022, closing low, meeting widely used criteria that mark the end of a bear market.
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The Dow Jones Industrial Average DJIA rose 65 points, or 0.2%.
But there are many skeptics who see a head fake rather than a newborn bull market. The concentrated nature of the S&P 500’s rally, which has been fueled to an extreme degree by gains in a handful of megacap tech-related stocks, has many investors wary that mid-cap stocks have been left behind.
While the market-cap-weighted S&P 500 is up more than 12% in 2023, the equal-weighted measure of the S&P 500 has gained just 2.6%.
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Others fear an uncertain economic outlook, arguing that a more pessimistic view reflected in the bond market could quickly undo the stock market rally if it turns out to be correct.
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And now what? Lee said that with the VIX below 14, it likely won’t be a driver of future earnings.
Now, the market faces what may be its “most consequential” week of the year, with May’s consumer price index due out on Tuesday and the Federal Reserve concluding a two-day policy meeting on Wednesday .
Traders in federal funds futures have priced in a roughly 72% chance the central bank will leave rates unchanged next week, according to the CME FedWatch tool, halting after a string of rate hikes which brought the benchmark rate from near zero to the current range of 5% to 5.25% since March last year. But they expect the Fed to hike in July.
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While the VIX at its current level isn’t necessarily a buy signal on its own, “we still see upside drivers for the S&P 500 over the next 6 months. The main driver is that inflationary pressures are easing faster than the consensus expects and at a pace that will allow the Fed to slow its rate of hikes,” Lee said.
With the caveat that next week’s events are crucial, Fundstrat’s base case remains that the S&P 500 will gain more than 20% in 2023, with the 4,300 level serving as a “benchmark” that will eventually give way in equity markets this year. , he said.