Daily Stock Market Reports

Fed May Spark The Next Leg Lower In S&P 500 On Massive Volatility (NYSEARCA:SPY)

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Expectations for a post FOMC bounce seem to be rising all around social media as investors look for a VIX meltdown, causing a massive spike in stocks. I would argue that risks are for the opposite, that the next leg lower for stocks is coming, led by an enormous spike in the vix index.

The S&P 500 ETF (SPY) is on the cusp of a significant move lower as valuations across the equity complex melt and move back to their historical average. As massive deleveraging occurs across Asia and even Europe, as risks rise for more COVIDrelated lockdowns in China, a war in Europe, and out-of-control inflation threaten a global recession.

Over the past 10 years, the benchmark index for the S&P 50 SPDR ETF (SPY), the S&P 500, has had an average PE ratio of 16.9 times its next twelve months’ earnings estimates. But currently, the index is still trading around 18 times those earnings estimates. A return to that average PE ratio would pull the S&P 500 index down to 3,920, or approximately $392 on the SPY ETF. That is about 250 lower on the S&P 500 or 6% below its closing price of 4,173 on March 14.

SPX Index chart


However, the data also shows that a true bottom in the markets typically doesn’t occur until the valuation for the index hits one standard deviation below the historical average or below 15 times its NTM earnings estimates. This is what happened in 2014, 2015, 2016, 2018, and 2020 all of which proved to be significant market bottoms at the time.

A push to 15 times NTM earnings estimates would value the S&P 500 at 3,474 or roughly $348 on the SPY ETF. That will be a drop of an additional 17.6% from its current closing price on March 14, and if this is an actual deleveraging process, which it is beginning to look like it may be. Then the case, for 3,500, although it may seem far out of reach, maybe closer to reality than it seems, and the risk for a further meltdown following the FOMC meeting are higher than what most investors seem to be thinking about.

The Fed May Spark The Next Leg Lower In The S&P 500 On Massive Volatility


Bonds Are The Risk

Most investors seem bullish about the FOMC meeting and ignore the risk. But the FOMC meeting isn’t about the danger to stocks. It’s about the risk to bonds. If bonds respond negatively to the FOMC, then equities will follow.

The yield curve has risen on the front of the curve dramatically over the past month, with the two-year climbing by more than 20 bps. But notice the flattening of the yield curve between the three-year and the 10-year yield which is now separated by just 10 bps, or nearly completely flat. This flat outlook suggests that the market doesn’t see the Fed raising rates much beyond 2%, where the significant risk lies.

The Fed May Spark The Next Leg Lower In The S&P 500 On Massive Volatility


The FOMC will release the dot plot and its projections tomorrow since this is a quarterly meeting. It’s an event where the bond market will find out that the Fed’s tolerance to raise rates may be higher than expected. Especially given that many Fed governors indicated that they see the odds of tightening monetary policy beyond the neutral rate as needed to get inflation rates down. Even Powell himself made light of this potential need in recent weeks when he testified in front of Congress. If the dot plots reflect the need to go beyond that neutral rate or above 2.5%, that would be viewed as a tectonic shift.

The Fed had last projected rates of 0.9% in 2022, 1.6% in 2023, and 2.1% in 2024, with a longer run rate of 2.5%. It seems highly likely that given the persistent rise in inflation, a rate of 2.5% or higher may show up in 2023 or 2024 and would likely be a big shock to the market.

FOMC Projections


Betting The VIX Rises

The options market appears to be hedging the risk of such a shock and the potential for an equity market that moves sharply lower following the Fed. There has been a lot of betting suggesting that the VIX rocket’s higher in the weeks ahead. The open interest levels for the VIX options jumped on March 15 for the April 20th, 40, 70, and 110 calls rising by around 12,500, 19,000, and 18,000 contracts, respectively. The 40 strike price calls were bought on the ASK for $2.44 per contract, the 70 calls were for $0.78 per contract, and the 110 calls were bought for $0.34 per contract. Additionally, the June 15th, 70 calls saw their open interest rise by roughly 86,000, with those calls purchased for approximately $1.35 per contract. Finally, on July 20th, the 60 calls saw their open interest rise by almost 29,000 and bought for roughly $2.00 per contract.

By contrast, the put activity was more muted, with open interest for the VIX June 15th, 21 puts rising by around 86,000 contracts on March 15, and bought for $0.70 per contract.

Overall call volume on March 14 was more than double the put volume, with the put-to-call ratio below the historical average over the past month. Not what would expect ahead of a massive rally in stocks and a big volatility meltdown.

VIX Historical Ratios

Trade Alert

Additionally, the implied volatility levels for the VIX have remained elevated, and the SKEW has been falling. Suggesting that the call prices are higher than a comparable put price. Not what one would expect to see ahead of a big volatility meltdown.

VIX Historical Volume

Trade Alert

Next Leg Lower

Meanwhile, the SPY has been consolidating sideways in a triangle pattern since the end of February. That pattern is now coming to its conclusion and attempted to break down on March 14. On March 15, that triangle is testing the upper trend line.

The pattern is a symmetrical triangle, a continuation pattern, considering the trend has been lower in recent months. It would indicate the next leg for the SPY is down.

The triangle measures about 7% from the Feb. 24 low to the March 3 high. A break of the lower trend would suggest that ETF drops by around 7% from the lower trend line of around $420. That would push the S&P 500 ETF to about $391.

The Fed May Spark The Next Leg Lower In The S&P 500 On Massive Volatility


It will be a very tricky FOMC meeting, filled with many details, but the days of the dovish Fed coming to the market’s rescue are over. The inflation mandate has spiraled out of control, and now the Fed will need to act before inflation gets even worse.

Good Luck!

Read More: Fed May Spark The Next Leg Lower In S&P 500 On Massive Volatility (NYSEARCA:SPY)

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