The SPY ETF May Be In For A Big Drop (NYSEARCA:SPY)
Volatility may be ready to go to a whole new level and very soon, especially for the S&P 500 ETF (SPY). The ETF has struggled lately as the Fed has threatened to start raising interest rates and shrink the size of its balance sheet. Additionally, there has been options activity in VIX, which could suggest the volatility is likely to spike in a big way over the next several weeks.
As a direct result of the Fed’s warnings, interest rates are rising and financial conditions are tightening. The change in rates and tighter conditions are helping to compress the PE multiple of the ETF’s tracking index, the S&P 500. That PE ratio is well off its highs of over 23 and currently at 19.7. However, It’s still too high when considering the amount of monetary tightening the Fed has threatened and where interest rates are.
The last time the 10-year rate was around 2% was in July 2019; at that point, the S&P 500 was trading around 17 times earnings.
At that point, the earnings growth rate was expected to be around 8%, which is just a little bit lower than current growth estimates for 8.7% over the next 12 months. It seems odd that with the 10-year rate at the same level as in 2019 and the growth rate around the same level as in 2019, today’s PE ratio is nearly 11% higher.
Additionally, the last time the Fed started a rate hike cycle in 2015, the PE multiple contracted. During that period, the PE ratio of the S&P 500 fell from around 17.3 to a low of 14.8, a drop of almost 15%. Given how high the PE ratio on the S&P 500 reached in 2020 and 2021, which were levels not seen in nearly 20 years, it’s tough to say just how much the multiple should contract. However, given historical trends, that number is likely to be between 15 and 17.
Betting Volatility Surges
All of the questions surrounding the Fed and potential for further downside risk to asset prices have allowed options traders to bet that volatility in the market picks up dramatically, and the S&P 500 falls as a result. On Feb. 16, the open interest for the VIX May 18 30 calls rose by around 23,000. The data shows that the calls were bought on the “ASK” for approximately $3.90 per contract. Then on Feb. 17, the open interest for the May 18 VIX 25 Calls rose by almost 35,000 contracts. The data shows these calls were bought on the “ASK” for approximately $4.55 per contract. These are two examples of some bets placed in the past two days that suggest the mindset among some investors is for higher volatility over the medium term.
While not all the options traded suggest volatility will rise, some even point to volatility falling. What makes those two specific trades mentioned above interesting is the length of time the traders were willing to take and the significant premiums paid to buy the options.
Technical Trends Breakdown
Additionally, the technical charts are very weak for the SPY. First, the SPY is falling out of a rising broadening wedge pattern, which tends to be a very bearish pattern. Second, the SPY formed a double top pattern from Feb. 2 through Feb. 9. That bearish reversal pattern was confirmed when the SPY fell below support $446.65. The ETF tried to rally back to that level of support at $446.65, and, despite multiple attempts, it was unable to get above that price. This indicates that resistance is strong at $446.65, and sellers are very much in control.
Additionally, momentum in the S&P 500 has broken down, with the relative strength index in an obvious downtrend. The RSI tells us that the SPY isn’t even close to being oversold yet.
This indicates the ETF falls below its January lows.
Given that we also face another monthly options expiration date on Feb. 18, it’s entirely possible that over the next few days, the period of sideways trading is ready to end and the next leg lower about to begin.