Euphoria was clearly taking over financial markets.
Now, the question is whether the rally will quickly get back on track or if this is the start of a bigger pullback in the stock market.
One warning sign suggesting more turmoil could be on the way is unusual movements in the closely-watched VIX volatility gauge.
In fact, the VIX hit its highest level ever at an all-time high for the S&P 500, according to Bespoke Investment Group and Goldman Sachs. The previous high was set in March 2000 during the dot-com bubble.
“It is a significant red flag,” Daryl Jones, director of research at Hedgeye Risk Management, told CNN Business. “The market is at a very risky point. It heightens the risk of a market crash.”
When US stocks rise and the VIX stays low (and often goes lower), that’s typically a green light for investors.
“You want to chase that. But higher stock market on higher volatility is telling you that risk is increasing,” Jones said.
Back then, it made sense that the VIX was going straight up. The S&P 500 had just suffered its worst single day since 1987. The Dow lost a stunning 2,997 points, or 12.9%. Selling was so extreme that trading was halted on the New York Stock Exchange for 15 minutes that day.
“It’s a worrisome sign,” Jim Bianco, president of Bianco Research, said of the high level of the VIX.
Bianco said that volatility typically goes down when stocks rise, because investors feel less of a need to buy the VIX as insurance against a decline. But that pattern has broken down.
“When prices go up in a way that gets people concerned the market is overdone and you have rising volatility and rising prices, that’s typically unsustainable and you do get a correction,” Bianco said.
Fed, vaccine hopes underpin five-month rally
The epic rebound on Wall Street has been driven by unbelievable levels of emergency aid from the Federal Reserve, which has slashed interest rates to zero, purchased trillions of dollars in bonds and promised to keep its foot on the pedal as long as it takes.
The most surprising part of the rise in the VIX is that it flies in the face of the easy money from the Fed that is designed to keep volatility in check.
Jones, the Hedgeye executive, compared the Fed’s efforts to dampen volatility to pushing a ball underwater.
“Eventually, the ball under water explodes higher,” he said.
But Randy Frederick, vice president of trading and derivatives at Charles Schwab, said concerns about the rise of the VIX in tandem with the stock market is a “little overblown.”
“It’s more of a caution flag than a panic button,” Frederick said.
First, he pointed to the fact that the VIX doesn’t typically predict market crashes as much as it reacts to them. Second, Frederick argued there are very legitimate reasons for investors to be nervous right now, namely the looming election and the pandemic.
“We have a very unusual situation here,” he said. “We have a very highly contested election in just 60 days and we still don’t know when we’re going to a vaccine to get out of this mess.”
Goldman Sachs strategists pointed out in a research note to clients Thursday that VIX futures contracts around early November have spiked, likely due to “investor fears about high volatility around the US elections.” In particular, the Wall Street bank said investors are likely concerned that election results will “take longer than normal to be processed.”
Paul Hickey, co-founder of Bespoke Investment Research, said that although there are explanations for why the VIX is so high, that doesn’t mean it should be dismissed.
“The market has had a big run,” Hickey told CNN Business in an email, “so when we do hit a bump in the road, the reaction is more likely to be more exaggerated than if we hit it coming in slow.”
Betting against this rally has been unwise, if not dangerous. But it won’t go straight up forever.