Since the pandemic started in early 2020, the stock market has been anything but normal. It shot up in late 2020 and 2021 only to fall hard in 2022. Of course, in that time, we've experienced some pretty dramatic events.
In addition to the COVID-19 virus, the Federal Reserve pumped trillions of dollars into the economy, there's been very high inflation, the Fed then raised interest rates faster than any time in the last 40 years, and there was a banking crisis earlier this year.
All of these events in the last three years have created a market dynamic that many do not entirely understand. In the latest sign of confusion, Wall Street's "fear gauge" and the bond market are now telling investors opposite stories. Let's take a look at what they are saying and what might explain the disparity.
Is the investing environment good or bad?
Investors use lots of different economic data points and indicators to help them understand market conditions and whether it's a good time to invest. One of those popular data points is the Chicago Board Options Exchange Volatility Index, or VIX, which many investors also refer to as Wall Street's "fear gauge."
The VIX measures how much volatility investors are expecting in the broader benchmark S&P 500 index over the next month. A high VIX number indicates that investors are predicting a lot of volatility, which means there is likely a lot of fear -- the S&P 500 tends to fall when this happens. But a low VIX indicates the market is not worried about volatility; thus the S&P 500 tends to rise.
As you can see from the chart above, the VIX is near some of the lowest levels seen since the start of the pandemic. In one regard, this makes sense with the S&P 500 having experienced a percent change of more than 13.5% this year.
But on the other hand, it's interesting that investors are so calm right now with what seems to be so much uncertainty regarding interest rates, the potential for a recession, and the prospects for economic growth. In fact, while the VIX is indicating calm conditions, the bond market is actually screaming that a recession is in the making.
2 Year Treasury Rate data by YCharts
As you can see in the chart above, the yields on the two-year U.S. Treasury bill and 10-year U.S. Treasury bill have been inverted since the second half of 2022, which is usually a flashing sign for a recession. Not only has an inverted yield curve preceded all nine recessions since 1955, but the curve in recent months has hit the steepest inversion seen in 40 years.
Could both be true?
One thought I have about these two seemingly opposite signals is that perhaps they are not so different after all. One thing to keep in mind about such a low VIX level is that the VIX tends to bounce up once it hits a low point, so a VIX nearing low levels could be preparing for a bounce soon, which likely wouldn't be good for the market.
Or perhaps traders are really calm right now and simply not worried about a recession. There is still the possibility that the U.S. economy avoids a "hard landing," and some investors believe that a recession is actually needed to get the Federal Reserve to cut interest rates, which would create more of a risk-on environment.
I obviously don't have a crystal ball, but I do think that both scenarios are possible. That's why it's important to dig into the data. These seemingly conflicting data points also show how difficult it can be to time the market based on a few data points. That's why investors should really focus on stocks with a long time horizon that can navigate periods of uncertainty and volatility.
