The Message Behind Yesterday’s Volatility Spike

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Yesterday was a reminder for traders who forgot what volatility feels like.

The S&P 500 had its biggest drop since June 25, and Cboe’s Volatility Index ($VIX.X) had its biggest spike over the same period. Even more impressive, TradeStation data showed 23.6 million options changing hands between the opening and closing bell. That was the highest total since late March.

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While media pundits blamed rising interest rates, chart watchers had a sense it was coming after the S&P 500 formed a bearish outside day on September 26. That potential reversal pattern, combined with a lack of positive news catalysts, was a problem for the bulls. (View Market Action for more.)

The interest-rate story is still important because we’re finally getting evidence of the yield curve steepening. In other words, long-term rates are rising faster than short-term rates. That’s a potential boon for banks that profit from the difference between the two.

Good economic news and surging oil prices lie behind the move. This week alone, ADP’s private-sector payrolls report crushed estimates, initial jobless claims fell more than expected and service-sector activity shot past forecasts to a 21-year high.

Meanwhile, a slew of policy wonks associated with the Federal Reserve — Jerome Powell, Charles Evans and Kevin Warsh, to name a few — have spoken glowingly about the economy. There’s also been chatter about rising wages, especially after Amazon.com (AMZN) boosted pay. Some of that points to higher inflation. All of it points to higher rates.

Oil’s another big, big catalyst because it’s one of the most important drivers of inflation. It’s also broken out to multiyear highs.

Inflation, by the way, can widen the yield curve because bond investors will demand more compensation for locking up their money over longer time frames.

The market seems to be adjusting to the new environment by shifting money into lower-multiple “value” stocks like financials and materials. Industrials are the other beneficiary because they’re among the biggest winners in a strong economy.

On the flip side, news like this can weigh on technology. Why should investors pay higher price/earnings ratios for new-fangled growth stocks when they can scoop up banks and life insurers at book value? Throw in the issues at Facebook (FB) and continued signs of a slowdown in the chip space, and the narrative may be even clearer.

In conclusion, Market Insights has recently highlighted the rotation away from Nasdaq stocks in favor of industrials. Real-world information seems to be confirming that trend. This isn’t a trade recommendation and everyone needs to do their own homework, but clients may want to keep this in mind — especially after today’s key non-farms payrolls report.

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David Russell is VP of Market Intelligence at TradeStation Group. Drawing on nearly two decades of experience as a financial journalist and analyst, his background includes equities, emerging markets, fixed-income and derivatives. He previously worked at Bloomberg News, CNBC and E*TRADE Financial. Russell systematically reviews countless global financial headlines and indicators in search of broad tradable trends that present opportunities repeatedly over time. Customers can expect him to keep them appraised of sector leadership, relative strength and the big stories – especially those overlooked by other commentators. He’s also a big fan of generating leverage with options to limit capital at risk.