The Market Is Looking Beyond the Election Results
Two years ago, my wife and I packed up our life in New York City and moved to South Florida.
I’ll never forget the drive down. It’s a 17-hour drive without traffic, so we took our time and enjoyed a night in Richmond, Virginia, and Savannah, Georgia.
After three days of travel and with 20 miles left to our destination, we encountered a typical late-summer Florida thunderstorm on Interstate 95 south.
It was dark, the rain was torrential and I couldn’t see more than 50 feet in front of me. The lightning strikes were happening all over the place, and our husky/Shiba mix cowered in the back seat.
So, I did what most drivers do in those conditions: I slowed down to 40 mph and put my hazard lights on.
Of course, this is Florida. Not everyone plays by those rules.
After a few minutes, I was passed by a white Jeep Cherokee as if I was standing still.
The driver had decided that even though the rain was torrential and the road was half-flooded, he was still going to maintain the 70 mph speed limit.
As he whizzed by me, the spray from a puddle was like a bucket being dumped on my windshield. A few seconds later, I saw his taillights quivering through the rain.
And then, suddenly, his headlights were facing me as I headed straight toward a head-on collision.
Thankfully, I had slowed down. That gave me ample time to stop without skidding out, as did the rest of traffic.
It was quite a scare, but we made it to our new home unscathed.
When I think of this experience, it reminds me of our current market climate as we await the results of the election…
The Market is Ready for the Election
In the last couple of months, investors have tapped the brakes on the stock market’s rally.
After an incredible rally from the March lows, the S&P 500 Index peaked in early September. Since then, it’s down 10% in the past two months.
Investors have reasons to be worried. There’s uncertainty around the U.S. election — not only the outcome but whether or not the results will be contested.
There are also concerns that the coronavirus spread will lead to shutdowns, as we’ve recently witnessed in Germany and England.
These events may seem like reckless Jeep Cherokees in a rainstorm. But there’s plenty of evidence that the market is ready for what may come.
Insurance for Your Portfolio
To see what the market is discounting, we can look at what institutional investors are willing to pay for insurance on their stock portfolios.
Think of the CBOE Volatility Index (VIX) like a car insurance premium.
When the VIX moves up, it becomes costlier to insure a portfolio of stocks. A higher VIX suggests that investors expect danger ahead.
This is similar to how car insurance premiums move higher if the insurance company sees you live in an area with more car thefts and accidents.
But these insurance premiums don’t tell the full story.
What I care about is how quickly the price of insurance is moving higher. That’s a better indicator of fear.
And to do this, I look at the volatility of volatility, or the VVIX.
When the VVIX spikes, it indicates that the cost to insure the market is quickly moving higher, as investors willingly pay higher prices.
And when everyone is reaching to buy insurance at the same time, it indicates that there’s a panic happening.
When people panic, they often act irrationally, such as by overpaying for insurance … or selling stocks at the bottom of the sell-off.
And that’s when strategic buyers can profit from investor panic.
The Best Fear Indicator to Watch
In the past five years, the VVIX has been extraordinarily accurate at forecasting market bottoms.
Since January 2015, there have been 10 occurrences when the VVIX crossed above 120.
And in nine out of the 10 times the VVIX has moved over 120, the three-month return of the SPDR S&P 500 exchange-traded fund (NYSE: SPY) was positive, with an average gain around 10%.
In March of this year, the VVIX traded as high as 210. Over the next three months, the SPY returned 34%.
It broke above 120 again on June 12, trading as high as 171. In the three-month period after, the SPY returned 11.4%.
Once again, the VVIX is sprinting higher. It jumped 30% last week, hitting a three-month high of 154 on Wednesday.
While this doesn’t indicate that stocks have bottomed, it’s a good sign that there’s enough fear that investors have tapped the brakes.
This means that investors are prepared for a negative event and makes it likely we’ll see higher prices three months from now.
But there’s always the chance that there’s not enough time to hit the brakes when you see a careening Jeep Cherokee in a rainstorm.
Editor, Automatic Fortunes