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Lower volatility heading into 2024 is a bullish sign for stocks, as the rebounding U.S. equities market nears record levels reached about two years ago.
The stock market’s “fear gauge,” the CBOE Volatility Index
VIX,
often referred to by its ticker VIX, is flashing “a positive sign” for 2024, said Nicholas Colas, co-founder of DataTrek Research, in a phone interview. “We’re in a low-volatility regime.”
The VIX is an options-derived index that reflects expectations for S&P 500 volatility over the coming 30 days.
In early 2023, Colas had pointed to the stock market’s fear gauge as “looking a lot more like 2021 rather than 2022,” saying in a late January note that “a structurally low VIX is much more conducive to a solid year for equity market returns.”
The S&P 500
SPX
has soared 19.4% this year through Thursday, with the index on track for its best annual performance since 2021 and just 4.4% from its record close on Jan. 3, 2022.
U.S. stocks have rallied as high inflation has fallen from its 2022 peak, but the S&P 500 is still trading around price levels seen a couple years ago, said Colas. The index’s earnings have been about “flat” for the last two years, he said. “We just need some earnings growth.”
Meanwhile, the VIX, which is trading below its early 2023 levels, is “very clearly saying” this is a bull market for stocks, according to Colas.
The VIX ended Thursday at about 13.1 That’s only slightly above its recent finish of 12.46 in late November, which marked its lowest daily closing level since January 2020, FactSet data show.
Colas said the gauge “clearly follows a market-cycle pattern” where stocks are in a bull market when it tracks below 20 for a long period, and in a bear market when it’s consistently above 20.
The VIX, which tracked higher in 2022 as the S&P 500 index plunged 19.4% in its worst annual performance since 2008, is back to levels seen around the end of 2019, FactSet data show.
“We wiped out all the volatility from the pandemic, inflation and the rate shock,” said Colas. “I’m surprised as anybody” that the VIX recently fell below 13, he said. “It rarely gets below 12.”
‘Figured out’
“The market feels that it has the Fed figured out,” said Colas. Many traders expect the central bank’s rate-hiking cycle is finished and that cuts to its benchmark rate are coming next year.
Investors also appear to anticipate that companies’ earnings results will be stable, with maybe “a chance for some better earnings next year,” he said. And beyond the central bank’s federal-funds rate, many people expect long-term rates will be lower, according to Colas.
Whether all those things move in expected ways remains to be seen.
“Markets are taking it for granted that the rate cycle is over,” cuts to the federal-funds rate are coming and there won’t be a recession, said Colas. That’s “a fair point of view given all that we know about the economy right now,” he said, but the market was wrong in March when it thought the regional bank turmoil in the U.S. was going to “instantly cool economic growth.”
The VIX briefly surged above 30 during intraday trading in mid-March, following the sudden collapse of Silicon Valley Bank. It raised anxiety about the potential toll of the Fed’s aggressive rate increases on balance sheets of regional banks.
See: What’s at stake for stocks, bonds as Federal Reserve weighs bank chaos against inflation fight
But the VIX’s closing levels fell below 20 by March’s end after the Fed swiftly set up an emergency funding program for banks. That’s even as, that same month, the Fed went on to raise rates, albeit at a slower pace than seen in 2022, and before pausing its hikes this year.
While the U.S. stock market stumbled in the third quarter as Treasury yields spike, it rebounded in November as the rate on the 10-year Treasury note
BX:TMUBMUSD10Y
fell. It was slightly more than 4.1% on Thursday, well below its 2023 peak of about 5% in October, according to Dow Jones Market Data.
The Fed seems “to have gotten inflation heading in the right direction,” while at the same time “employment seems still very healthy,” said George Patterson, chief investment officer of PGIM Quantitative Solutions, in a phone interview. “We don’t see an impending recession.”
Despite the central bank holding its benchmark rate at the highest level in 22 years since its July policy meeting, financial conditions eased in November as stocks and bonds saw strong rallies.
Next year’s gains may stem from a broader group of equities, said Patterson, in contrast with the market’s rise this year being propelled by a handful of megacap stocks known as Big Tech.
“U.S. large-cap growth has been a party,” he said. “Everything else has somewhat been ignored.”
Patterson said he’s expecting below-trend growth for 2024, as well as smaller stock-market gains. Returns will probably be closer to “long-term averages,” potentially around 6% to 8%, he said, adding that in the U.S. he likes small-cap equities and value stocks.
‘Biggest risk’ for markets
While the U.S. economy has so far remained resilient despite the Fed’s tightening of monetary policy, “the biggest risk” for markets is that “inflation stays elevated because the labor market stays hot,” fueling wage growth, said Colas. In that case, “the Fed’s job may not be done.”
That could mean another rate hike or simply that “the Fed doesn’t cut at all next year,” he said.
While the VIX is a positive sign that “we are reliably in a bull market,” the fear gauge’s particularly low level recently doesn’t necessarily mean U.S. stocks are going to rip next year, according to the DataTrek co-founder.
“The caveat is the VIX is seasonal” over the course of the year, particularly in December, when it most often makes lows, said Colas, pointing to the seasonally anticipated “Santa-Claus” rally.
He also dismisses the notion that a low VIX is a sign of complacency in the stock market. “It’s a misreading of history,” he told MarketWatch. “The VIX stays low during bull markets. It’s just what it does.”
Watch bond-market volatility
Meanwhile, the bond market’s volatility gauge, the ICE BofAML MOVE Index, is “still very high,” after recently subsiding, according to Simplify Asset Management managing partner Harley Bassman, who created the measure decades ago.
The MOVE Index, which measures interest rate volatility, ended Thursday at nearly 130. That compares with a close of almost 200 in mid-March and a more recent finish that was as high as 135 in late October, FactSet data show.
“The MOVE coming down is very bullish for everything,” Bassman said in a phone interview. “It gives you time to adjust your portfolio. You don’t need to have like five seat belts on anymore.”
Both stocks and bonds tumbled in the U.S. last year as the Fed aggressively raised rates to cool the hottest inflation in more than 40 years. While the rapid rate hikes spurred fears among Wall Street analysts that the U.S. economy would fall into recession in 2023, it has so far remained resilient with an historically low unemployment rate in October.
Colas says the MOVE Index remains elevated in the central bank’s tightening cycle, after it was long suppressed by years of easy monetary policy after the 2008 global financial crisis.
Soft landing in 2024?
Still, market volatility has recently eased as many investors anticipate the Fed’s benchmark rate has peaked and may move lower as inflation falls under a “soft-landing” scenario, according to Bassman. That’s a shift from worries over how much higher the Fed might keep raising rates despite such hikes increasing chances of triggering a “hard landing” for the economy, he said.
Many investors are “shrugging off” the risk of a hard landing seen when U.S. unemployment spiked during the COVID-19 crisis of 2020 and the global financial crisis, while instead appearing to expect that “a slow-grind recession” would be manageable, according to Bassman.
In his view, the recent decline in the MOVE Index and low VIX may be a sign that wherever the economy ends up, it will probably get there in “a reasonably controlled manner.”
More from the series: What investors can expect in 2024 after a 2-year battle with the bond market
