Stock-market rally has likely reached a 'tipping point' following spike in Wall Street's 'fear gauge'

By Joseph Adinolfi

Analysts warn a rising Vix coupled with increased demand for bearish options likely signals more weakness for stocks ahead

After five months of calm, the stock market's incredible march higher was interrupted last week as Wall Street's "fear gauge" spiked. Some analysts believe it signals the beginning of a more serious pullback.

The Cboe Volatility Index VIX, otherwise known as the Vix, is stoking concerns that stocks could be headed for a correction - that is, a retreat of 10% or more from a recent high - after the fear gauge increased by 23% last week, its biggest weekly jump since September. The index finished north of 16 for the first time since Nov. 1, according to FactSet data.

The Vix measures implied volatility, meaning how much traders' expect stocks to move over the coming month, based on activity in the options market. Volatility tends to rise more quickly when stocks are falling.

A rising Vix coupled with a pickup in demand for bearish put options are signs that the market has likely reached a "tipping point" and could continue to soften in the weeks ahead, according to Tyler Richey, co-editor of Sevens Report Research, in a report shared with MarketWatch on Monday.

Richey suggested a repeat of the selloff that sent the S&P 500 down 10% between late July and late October of last year appears to be the most likely scenario for markets.

Demand for bearish put options also rose last week, pushing the 10-day rolling average of the Cboe equity put-call ratio to 0.661 on Friday, the highest reading since Jan. 26, according to Dow Jones Market Data. The equity put-call ratio measures demand for options tied to individual stocks, according to Cboe.

Specifically, a jump in demand for risky out-of-the-money puts caught the attention of Charlie McElligott, a derivatives strategist at Nomura.

According to McElligott, the pickup caused a gauge that measures demand for out-of-the-money puts compared with out-of-the-money calls to rise, as traders bought puts while demand for bullish calls cooled.

That sent the gauge of so-called options-market skew rising to 1.34, putting it in the 26th percentile going back to 2000, according to data from Nomura. But it wasn't the level of the gauge that McElligott found notable so much as the steepness of its increase off historically low levels from March, when skew had fallen to one of its flattest levels on record.

According to McElligott, previous instances when skew has risen this dramatically from such a low base have generally coincided with stretches of remarkably weak excess returns for stocks. Excess returns measure stocks' gains or losses measured against their historical average performance during a given period of the year.

Taken together, these indicators could mean markets are poised for more near-term pain as investors await the release of the March consumer-price index on Wednesday, which is expected to show that price pressures remained well above the Federal Reserve's 2% target last month. Investors will also contend with a series of Treasury auctions that could drive bond yields higher this week, as well as the start of the first-quarter earnings season.

But these aren't the only risks that could contribute to a "phase shift" for markets that could see stocks go from calm to rocky, according to McElligott.

Other, more slow-moving catalysts include a strengthening economy which is pushing back expectations for Federal Reserve interest-rate cuts; an "impulse tightening" of financial conditions driven by rising real yields and higher crude-oil prices; an earnings-season blackout period for corporate buybacks; and a liquidity drain as U.S. investors pay their taxes.

Other analysts cautioned against reading too much into last week's volatility spike, although they agreed with McElligott that the market's rally is looking increasingly vulnerable.

"The most notable thing is the fact that it happened at all. We've had this quiet period since November. Things were looking like they were going to go up forever. We got a little crack there - it is not a big one, but it is there," said Matt and Mike Thompson, co-portfolio managers at Little Harbor Advisors, in an interview with MarketWatch.

A put option represents a bet that a given issue or index will fall, while a call option represents a bet that it will rise. Options are considered "in the money" if the stock or index that the option is tethered to has moved past the strike price by enough of a margin to compensate the holder for the price of the contract. The strike price is the agreed-upon price at which the underlying stock or index can be bought or sold before the options contract expires.

U.S. stocks finished mixed on Monday, with the S&P 500 SPX down two points, or less than 0.1%, at 5,202.39, while the Dow DJIA was off 11 points, or less than 0.1%, at 38,893. The Nasdaq Composite COMP was up five points, or less than 0.1%, at 16,253.

The Vix finished lower, down 5.1% at 15.22. The S&P 500 rose nearly 30% between late October and the end of March without a single 2% daily pullback, according to FactSet, an exceedingly rare feat for markets.

-Joseph Adinolfi

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04-09-24 0700ET

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