Volatility (VXX) Set to Return?

A closely followed measure of stock market volatility known as the CBOE VIX (VXX) has spent the better part of 12 months at historically low levels, a sign that investors were optimistic about the health and direction of the market. However, as a mean-reverting indicator, volatility has witnessed sharp fluctuations during that period. Although volatility has remained very low since the U.S. election result, analysts believe it may be set to move higher now that President Donald Trump has all but abandoned globalization.

The Chicago Board Options Exchange (CBOE) Volatility Index, which tracks investor fear using S&P 500 index options prices, has declined nearly 20% this year. The index reached multi-year lows in January, as U.S. stocks continued to set new records. The so-called “fear index” reached a low of 10.58 on January 27. It trades on a scale of 1-100, where readings below 20 are normally associated with periods of complacency in the market.

Open interest in the VIX has surged in recent years as more traders make volatility-as-an-asset part of their investment portfolio. For these traders, capitalizing on volatility is essential to remain competitive in a market that experiences sharp fluctuations triggered by a multitude of forces ranging from economic data to monetary policy and even geopolitics. For these reasons, many investors expect volatility to slowly creep higher as the year progresses.

For starters, U.S. President Trump has issued a flurry of executive orders that may undermine global stability. Shortly after being inaugurated President on January 20, Trump formally withdrew the United States from the Trans-Pacific Partnership (TPP) and vowed to renegotiate the North American Free Trade Agreement (NAFTA), the deal that has governed trade between the United States, Canada and Mexico since 1994.

In addition to an uncertain trade climate, Trump and Congress will likely run into obstacles implementing a massive infrastructure spending program that the Republicans promised would fix American roads, bridges and airports.[1] Trump has promised to spend up to $1 trillion over ten years rebuilding America. This triggered massive rallies in materials stocks, which directly benefit from infrastructure spending.

U.S. multinational investment bank Goldman Sachs recently warned that the stock markets could be overstretched in the wake of Trump’s election victory. The massive stock market rally since November 8 has been fueled entirely by hopes that the U.S. economy would surge after Trump took office. Economists are now re-evaluating those expectations.

“Following the election, the positive shift in sentiment among investors, business and consumers suggested that the probability of tax cuts and easier regulation was seen to be higher than the probability of meaningful restrictions to trade and immigration,” Goldman Sachs economists wrote in a note published in early February. “One month into the year, the balance of risks is somewhat less positive in our view.”[2]

Goldman also warned that Trump’s protectionism, combined with less ambitious tax cuts, could depress market sentiment as investors lose hope in a major economic revival.[3]

For investors, this means volatility could be making its way higher. That’s because the VIX is inversely related with the S&P 500 Index about three-quarters of the time, which means it usually rises when stocks fall and declines when equities go higher.[4]

The last time volatility spiked was in the week leading up to the U.S. election. The VIX reached a high of 22.51 in early November as stocks experienced a nearly two-week reversal. Prior to that, the last major spike occurred following the June 23 Brexit vote, which triggered the biggest equities sell-off on record.[5] VIX surged above 25 after the United Kingdom voted to quit the European Union.

The VIX becomes a powerful investment during uncertainty because it allows investors the possibility to profit from falling market conditions. As investors grow more fearful of a Trump letdown, volatility may provide impressive growth during negative market cycles.

In addition to Trump, volatility could rear its head in many ways over the next several months. Elections in Europe, monetary policy developments and a steady stream of economic data are all expected to influence market sentiment.

Risk-aversion is already being reflected in the precious metals market, with gold and silver soaring to three-month highs in February. This is another sign that stocks may be losing their zeal.

To learn more about volatility-as-an-asset, visit easyMarkets, one of the only online brokers offering the VIX as a Contract for Difference (CFD).

[1] Sam Bourgi (February 6, 2017). “S&P 500 Futures Retreat as Energy Leads Market Lower.” Economic Calendar.

[2] The Irish Times (February 6, 2017). “Goldman Sachs economists starting to worry about Trump.”

[3] Ted Kim (February 7, 2017). “Goldman warns of market disruptions if Trump keeps pushing protectionist ideas from campaign.” CNBC.

[4] Sam Bourgi (November 16, 2016). “CBOE VIX: Volatility Continues to Plummet in the Wake of Trump Election Win.” Economic Calendar

[5] Matthew J. Belvedere and Peter Schacknow (June 28, 2016). “After $3 trillion in post-Brexit paper losses, global markets bounce.” CNBC.

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