Potholes Ahead For The Stock Market (BATS:VIXY) (2024)

Since the June Fed meeting, the news for stocks could not have been more bullish. The S&P 500 index was 3.79% higher in Q2, and over the first six months of 2019, it appreciated by 17.35%. Over the early trading sessions of Q3, the index has moved even higher along with the DJIA and tech-heavy NASDAQ.

The Fed told markets that short-term interest rates are heading lower during the second half of 2019, which is bullish for stocks. The trade summit between Presidents Trump and Xi at the G20 meeting on June 29 resulted in a moratorium in any new tariffs and a pledge to restart negotiations which injected some optimism into markets. The meeting between President Trump and Chairman Kim Jong Un of North Korea increased confidence that an end to hostilities in the DMZ could be on the horizon. The stock market got lots of good news over the first three trading sessions of July, and the memories of selling in Q4 last year and in May when the trade dispute escalated faded in the markets rearview mirror. However, the leading indices are now at levels where they failed in the past, and while it appears that there is blue sky above for new and higher highs in the stock market, there are many potholes that could derail the current optimism.

The ProShares VIX Short-Term Futures ETF (BATS:VIXY) tends to move higher during corrective periods in the stock market, and it is now falling to a level along with the VIX index that could be in the buying zone for the coming weeks.

New highs in the S&P 500

The beginning of the third quarter of 2019 took the S&P 500 to a new record high.

Source: CQG

As the weekly chart shows, the E-Mini S&P 500 futures contract rose to a new peak at 3,006 at the start of Q3. Open interest, the total number of open long and short positions in the futures market dropped from 3.066 million contracts in mid-June to 2.588 on June 3, but the decline occurred as the June futures rolled to September. Price momentum is in overbought territory, and relative strength is also in the same zone. Weekly historical volatility at 15.02% is at close to the midpoint so far in 2019.

The VIX retreats

The rise in stocks caused the VIX to decline. The VIX measures the implied volatility level of put and call options on the S&P 500 stocks.

Source: CQG

As the chart shows, the VIX dropped to a low at 12.04 on and was trading at 13.21 on July 5. The volatility index moved to the lowest level since April when it hit a low for 2019 at 11.03. It makes sense that a new high in stocks led to a decline in the VIX, but the volatility measure continues to reflect the potential factors that could turn the stock market around in the blink of an eye over the coming weeks and months.

Since the July 4 holiday was on Thursday, we are now in the heart of the summer vacation season that lasts until early September. However, over the coming weeks, more than a few issues could hit the stock market like a ton of bricks and lift the VIX and the prices of VIX-related products.

The Fed could throw the market a curveball

The market expects the US Federal Reserve to lower the Fed Funds rate by 25 basis points at the end of July. While the central bank is likely to follow through on its guidance from the June meeting, the data-driven members will be highly sensitive to the latest economic reports. At the same time, while the trade summit did not lead to a deal, it did inject optimism into markets which caused at least one of the “crosscurrents” to decline when it comes to the inputs for a decision by the Fed. If the FOMC decides to wait for further data at the July meeting, the disappointment could lead to selling in the stock market that expects at least a 25-basis point decline at the end of this month. A curveball from the Fed would likely knock some of the bullish wind out of the stock market’s sails and cause the VIX to move higher.

Friday’s employment data that said the US economy added 224,000 jobs in June, which was more than the market had expected, is a data point that could make the Fed think twice before increasing the Fed Funds rate at the July FOMC meeting. The unemployment rate at 3.7% is close to the lowest level in one-half a century.

Trade, Iran, Brexit, the US election, and many more factors are potholes in the road to the upside

While Presidents Trump and Xi agreed to restart trade talks and China will purchase some agricultural products from US farmers, there are no guarantees that President

Trump become frustrated again and slap tariffs on $300 billion of Chinese imports. If the Chinese negotiators try to backtrack further, the chances are high that the administration will walk away from the bargaining table. With bipartisan support to hold China’s feet to the fire for a new trade agreement, there is no pressure on President Trump to reach a deal in the immediate future. It is more likely that he will take a hard line in talks and could stop the process once again.

Iran’s enrichment of uranium is an issue that could trigger hostilities in the Middle East over the coming weeks. At the same time, any more attacks on oil tankers, the Saudis, or US military near the Strait of Hormuz would likely prompt a swift and severe response. Violence in the Middle East would likely cause selling in the US stock market.

The UK will get a new Prime Minister over the coming weeks, and Boris Johnson, the former Mayor of London and ex-Foreign Secretary is the leading candidate. However, the division within the Parliament over Brexit together with the potential of a hardline approach by Mr. Johnson could trigger a no-confidence vote and a general election in the UK. The rising potential for a hard Brexit could weigh on markets across all asset classes over the coming weeks.

The US election is kicking into high gear. Just a few days ago, it appeared that former Vice President Joe Biden would receive his party’s nomination to take on incumbent President Donald Trump. However, after the first round of debates, Mr. Biden’s support declined with three candidates; Kamala Harris, Elizabeth Warren, and Bernie Sanders nipping at his heels. The opposition party has moved decidedly to the left with the growth of support for Democratic Socialism. The Democrats support higher taxes, more regulations, and universal health care which could weigh on stock prices if they continue to lead in the polls. While the election is not until November 2020, the election of a candidate from the other side of the political aisle would likely weigh on the stock market.

While all of these factors have the potential to trigger a correction in the stock market, the unknown and surprise event can always cause a rocky road. All of the bullish news when it comes to lower interest rates, growing corporate earnings from tax and regulatory reforms are already baked into the stock market. The bullish freight train is currently chugging along, but any potholes could quickly derail the current rally.

The VIX and VIX-related products are back in the buy zone

With the VIX at around the 13 on July 5, the volatility index is now in the buy zone again. The profile of the ProShares VIX Short-Term Futures ETF (VIXY) states:

“The investment seeks investment results, before fees and expenses, that over time, match the performance of the S&P 500 VIX Short-Term Futures Index for a single day. The index seeks to offer exposure to market volatility through publicly traded futures markets and is designed to measure the implied volatility of the S&P 500 over 30 days in the future.”

The most recent top holdings of VIXY include:

Source: Yahoo Finance

Since VIXY holds positions in the VIX futures, it does an excellent job tracking the volatility index. However, it is a short-term product, so tight stops on positions are a good idea. If the VIX continues to drop, stopping out will allow for re-entry at lower levels as it is virtually impossible to pick bottoms or tops in markets.

Source: Barchart

VIXY was at $19.51 per share on July 5, which was just above the recent low at $19.27. VIXY fell to a new low with stocks at record highs even though the VIX is slightly elevated and remains above the mid-April low.

VIXY hast net assets of $240.43 million and trades over two million shares each day on average. If stocks hit another speed bump or worse, and the VIX lurches higher, VIXY will go along for the bullish ride. I believe that risk-reward favors the long side in VIXY but be prepared to stop out and re-establish longs at lower levels as the current trend is running counter to the volatility products.