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An unusual drawdown is the perfect ending to an unusual bull market

Equities 6 minutes to read
PG
Peter Garnry

Head of Equity Strategy

Summary:  The current drawdown is soon six months old in the S&P 500 and one of the deeper ones over the past 100 years, but it also one of the more strange drawdowns as the selloff has so far been orderly without panic days. The VIX Index and especially the VIX forward curve have deviated a lot from past observations relative to selloff in 2022. Intraday momentum strategies and a change in investor preference on option protection are two hypotheses behind what we observe. Our argument is that we have not seen the trough yet in S&P 500 and that we need to see the VIX forward curve to invert before we can call it a bottom.


The VIX is stubbornly low relative to selloff

The VIX closed at 28.36 yesterday despite a rather big selloff in the S&P 500. While the average level in the VIX Index has been quite elevated during the entire pandemic it has not reached alarming levels during the drawdown in 2022. We have highlighted it before in our daily Saxo Market Call podcasts and recent equity notes, that the selloff this year has been unusually calm and orderly relative to what we have observed historically.

The VIX forward curve typically inverts (the VIX Index spiking relative to the 2nd VIX futures contract) during market stress or panic, but this time we have not seen that behaviour. Compared to some of the daily moves and the current drawdown depth we have not seen the inversion in VIX which speaks loudly of the unusualness of this drawdown. JPMorgan strategists have recently written about this odd behaviour in the VIX and they argue that the “new structure” has formed over the past two years due to potentially a crowding in intraday momentum trading strategies and a potential shift in option gamma dynamics, with the latter being a function of investors preferring spreads for protection instead of outright puts.

It is ironic that the golden period of 2012-2021, with its brief declines followed by subsequently new and stronger highs due to extraordinary declines in interest rates and higher risk tolerance by investors, is now coming to an end in an unusual way. The market dynamics are very difficult and when combined with the most complex macro environment since the 1970s, many traders and investors have difficulties navigating the market.

Our core thesis is still that inflation will remain higher than consensus and for longer, and that the global economy will eventually slip into a recession. Under higher inflation and interest rates, equities will not come back to its lofty expectations and equity valuations, and thus valuation multiples will continue to act as headwinds on equity returns. We still prefer themes such as commodities, renewable energy, logistics, semiconductors, defence and cyber security.

VIX Index | Source: Bloomberg
VIX forward curve in %
VIX forward curve vs S&P 500 daily returns
VIX forward curve vs S&P 500 drawdowns
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