Correction Watch: Divergences are Developing Between Large US Stocks and Everything Else
Last week we put out a succinct mid-quarter update in which we highlighted 9 negative inputs into a tactical equity framework. This post builds upon that by calling out 7 rather conspicuous divergences that are developing in the financial markets.
The VIX index is rising while stocks are rising. Typically, implied volatility (what is measured by the VIX) tracks realized volatility. Realized volatility almost always falls when stocks rise. Since mid-August, however, what we are seeing is realized volatility fall while implied volatility rises. It’s an odd configuration that suggests options investors are pricing in higher probability of a selloff than equity investors. The current divergence between these two series is by far the largest it’s been all year.
The headline S&P 500 index keeps going up, but on fewer and fewer participating stocks. Typically, breadth in the equity market tracks the price level of the headline index. But that hasn’t been the case since mid-August. Since then, the S&P 500 has tacked on almost 100 points while Bloomberg’s cumulative breadth measure has fallen by 2%. Almost all of the rise in the S&P 500 has been due to a few large companies driving the gains. That usually isn’t a sustainable setup so we need to see breadth catch up for the correction risk to recede.