The VIX Tests 40 Before Small-Cap Stocks Lead a Bounce Back Rally

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(Monday Market Close) Stocks started the week in a downslide, with the S&P 500 (SPX) falling nearly 4% after the open. However, small-caps stocks started the intraday recovery with the Russell 2000 (RUT) bouncing off its morning lows after falling 5.5% in the morning. The small-cap index rallied back into positive territory and closed 2.29% higher thanks in large part to energy stocks. The S&P 500 and the Nasdaq Composite ($COMP) were also able to bounce off their lows to close in positive territory.

The massive sell-off and recovery could be the sign of capitulation that investors have been hoping for. When finally backed into a corner with what appeared to be real panic selling, bargain hunters seem to have stepped in and started buying. It could also be a good sign that investors started their bargain hunting with the riskier small-cap stocks demonstrating that these stocks have fallen to valuations where the risk is low enough to make the companies worthwhile. Even bitcoin rallied to positive territory alongside small caps, reflecting the change in appetite for risk.

Hopefully, over the next week, the larger companies can demonstrate greater strength. They could get some help from Dow Jones Industrial Average ($DJI) stocks because half of them report earnings this week. In fact, International Business Machines (IBM) reported after the closing bell and rallied 6.79% on the news that the company beat on earnings and revenue forecasts. The company had been working on a turnaround plan that appears to be taking shape particularly in its cloud services division. The Dow Jones closed in the green despite being down 1,100 points intraday. It was helped by Home Depot (HD), which traded 4.21% higher on the day. 

Despite the roller coaster of a day, some stocks rallied. Kohls (KSS) rocketed over 36% on news that an activist investor consortium led by Starboard Value LP proposed a deal valued at $9 billion. Clothing stocks appeared to be hot because Gap (GPS) also rallied 7.94% because some investors may be thinking that it also has merger potential. Domino’s Pizza (DPZ) rallied 4.85% despite no immediately related news.

Oil prices fell despite the continuing tension at the Ukrainian and Russian border. The United States and the United Kingdom have withdrawn some diplomats from Ukraine as NATO sends more ships and fighter jets to Eastern Europe. Rising tensions in the oil-rich area could cause oil prices to move higher.

A Week to Test Wills

This could be a big week for stocks with heavy hitters like Apple (AAPL), Microsoft (MSFT), and Tesla (TSLA) reporting. Additionally, the Federal Reserve will meet this week and hopefully lay out a plan for hiking interest rates in the near future; this could give investors some confidence in their plan to curb inflation. While these news events will be great for those of us who write market commentary, they could spell headaches for investors.

Stocks like Apple and Tesla often provide an insight into investor psychology, so this week could be a “vote of confidence” from investors on market strength. Apple has been a mainstay for investors and has often demonstrated strength compared to other technology stocks. Even with the recent pullback, Apple is down about 11% compared to the Nasdaq Composite ($COMP), which is down more than 16% from its highs. Tesla has been a “buy the dip” kind of stock, and investors have been willing to go to that well several times. However, with the Fed raising rates, investors may not be so willing to drink from these wells.

Despite the enormous rally to end the day, there’s no reason for volatility to fade. The bears could strike back later this week over concerns about earnings for technology companies, particularly those that deal in the cloud. Fortunately, IBM was able to show progress in its cloud business, but Microsoft had a range that stretched more than $20 on Monday.

The problem comes with rising rates and investors still trying to determine valuations. Pandemic plays were all over the map, with Netflix (NFLX) falling 11% to close down 2.60%. Zoom (ZM) rallied 3.58%. Peloton (PTON) rallied 9.79% as activist investors cry for the CEO to be fired and the company be sold. Finally, DocuSign (DOCU) also fell more than 7% but closed 4.91% higher.

Correction Vs. Bear Market

As previously noted, the Nasdaq is in correction territory. A correction is classified as a market pullback between 10% and 19%. A bear market is a declining market that has dropped 20% or more. The Russell 2000 (RUT) small-cap index was down about 20% at its intraday lows on Monday, which would’ve put it in bear market territory. All other major indices including the S&P 500 (SPX) and Dow Jones Industrial Average ($DJI) are near correction territory.

A correction can be quite healthy for stocks in that it helps weed out overvalued companies and allows other stocks to revert to their earnings means, or in other words, trade more in-line with their actual earnings growth. A bear market is different in that it tends to signal that there may be something wrong with the underlying economy. Stocks are commonly said to run about six months ahead of the economy.

The VIX (Cboe Market Volatility Index) can be helpful in signaling a correction versus a bear market by paying attention to certain levels. In 2021, market pullbacks often turned around when the VIX was near 30 (see below). However, in 2020, that level was around 40. And that 40 level stretches back into the previous two decades. The dot-com bubble burst and the bear market bottomed out soon after the VIX hit 40. But the 2008 credit crisis changed everything. The VIX can now spike above 40 during a correction, and the last two bear markets saw spikes around 90 before creating bottoms.   

CHART OF THE DAY: THE RUB ON THE VIX. The VIX, or Cboe Market Volatility Index (VIX), has broken above its 2021 reversal level (red line upper chart) and is testing a long-term reversal level (blue line in both charts). Data Sources: ICE, S&P Dow Jones Indices. Chart source: The thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.

Language Barrier

The world’s central banks don’t appear to be speaking the same language as the U.S. Federal Reserve is talking about tightening the U.S. money supply. European central banks are holding off on tightening as long as possible. And Asian central banks are increasing their money supplies to stimulate their economies.

The Federal Reserve is meeting this week to discuss its monetary policy plans. The Fed has greatly reduced its bond-buying stimulus efforts and should quit them entirely by March. Then the markets are expecting the Fed to increase the overnight rate by a quarter of a point in March. This is because the Fed is concerned that the higher rate of inflation is at risk of becoming structural and not transitory.

European Central Bank President Christine Lagarde has rejected calls to increase rates to combat soaring inflation and prefers to wait on the inflation problems correcting themselves as supply chain bottlenecks open up and producers get back to work when COVID-19 restriction are lifted in Europe. The largest increases in prices have been due to energy prices, so getting through the winter months could also be a big help. Lagarde stated that an important difference is that Europe isn’t seeing the “excessive demand” that the United States is.

Last week, the People’s Bank of China cut a couple different interest rates to try and stimulate economic growth. China isn’t seeing the same degree of inflation because consumer spending has slowed, regulations have tightened, and the property sector is struggling. The housing market has been troubled by overborrowing from homebuilders and now they need to refinance the debt to lower levels, so it becomes more serviceable.

These conditions are likely to push the U.S. dollar higher, which has normally been a drag on large- and mega-cap international companies and help domestic small-cap companies. Perhaps this morning’s small-cap led rally is a good sign that investors are recognizing the favorable position for the group.

TD Ameritrade® commentary for educational purposes only. Member SIPC.

Image sourced from Unsplash

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