Traders are anticipating that the relative calm that has pervaded the market throughout the summer is about to come to an abrupt end.
One indicator is coming in the VIX futures market — the place where market participants place bets about the path of the CBOE Volatility Index, a popular fear gauge. The index usually moves inverse to the direction of the S&P 500.
Traders of late have been heavily short the VIX, meaning they are betting against its rise and by extension looking for the stock market to be positive.
At first glance, traders are so against the index that it looks like a setup for what happened in February, when a spike in volatility crushed holders of exchange-traded funds that were short the VIX. Commitments of Traders data shows a net short position near its peak for the year.
However, futures contracts in the months ahead indicate that a return to at least a normal level of volatility is anticipated.
“Looking at the VIX term structure, the market is bracing for some sort of volatility event in the next two to three months,” Russell Rhoads, head of derivatives research at the TABB Group, said on the research outfit’s pay site. “This extra risk premium in the futures seems to be bringing back the short volatility trade.”
The VIX opened Wednesday around 12.5. The November contract was looking at a 15.56 level, representing about a 25 percent gain.
It’s not exactly February-style volatility, where the VIX peaked out near 40, but it does represent a substantial change in conditions.
“The spread now is attractive enough, based on the spread between VIX and the futures, to bring volatility sellers back into the market,” Rhoads wrote. “Therefore, despite the increase in short positions, the best read on VIX is that the market is going to be on pins and needles the next few months.”
What would serve as a driver for the anticipated jump in volatility is an open question.
After all, the market has plowed through months of worries over a trade war, geopolitical tensions and various other eruptions, including a looming inversion in government bond yields that could signal a recession ahead.
One theory is that with the summer slumber over, markets simply will start paying more attention to those headwinds.
“The recovery to January’s highs was driven by ~25% earnings growth in 1Q and 2Q, subsiding inflation concerns, low yields and a willingness to worry about trade later. However, we see several risks endangering the rally,” David Bianco, Americas chief investment officer at DWS Group, said in a note.
Bianco sees dollar strength, a pullback in emerging markets geopolitical issues in Italy, Brazil and elsewhere and midterm elections in the U.S. serving as further obstacles. In addition he said high valuations for the pivotal tech leaders also serve as a potential trouble spots and making “the S&P more susceptible to any domestic or international negative developments.”
In all, Bianco predicts a 5 percent to 9 percent downturn for the S&P 500, “but worse than that is also a possibility given the uncertainties.”