Is the Stock Market Ready for Another Large Selloff?

Markets have experienced a broad bullish period in recent months as investors bet on further stimulus from the governments and the central banks, and the prospect of a coronavirus vaccine.
 
Despite lingering global economic risks from the Covid-19 pandemic and geopolitical global tensions, the S&P 500 and the NASDAQ both notched recent record highs, while the Dow Jones closed above 29,000 points for the first time since February 2020. Could a phenomenon known as the “Minsky moment” bring an end to the bull market?
 
Minsky Moment
 
A “Minsky moment,” named after economist Hyman Minsky, refers to a sudden market collapse following an unsustainable bull run, which in this case could be fueled by the “easy credit” environment created as a result of unprecedented fiscal and monetary stimulus measures.
 
A number of different warning signs on the horizon indicate that a “Minsky moment” could occur.
 
Tech Driven Recovery
 
Recent market gains were significantly driven by the U.S. tech giants known as FAANGs (Facebook, Apple, Amazon, Netflix and Google). While the U.S. is continuing to be ravaged by the coronavirus pandemic and widespread civil unrest, the stock values of the FAANGs have not only recovered but posted significant gains since the beginning of the year. All FAANG stocks have outpaced the S&P 500 and Russell 2000 small cap indices, with Amazon leading the pack with a year-to-date gain of 74%. The S&P 500 and the Russell 2000 have only increased by 17% and 15%, respectively. See table “YTD Performance – FAANGs vs Stock Indices” for details.

The tech driven recovery is even more clearly visible when looking at the equal weight S&P 500 index, which assigns a fixed weight to each stock rather than using market capitalization as weight. Think of the equal weight S&P 500 as a pie whose slices are all the same size, while the market capitalization S&P 500’s slices are all different.
 
The first difference between these two indices is that the equal weight S&P 500 index is down 4% since the beginning of the year. It began the year with 4691 points and closed with 4498 points on September 4, 2020. Second, the equal weight S&P has not been able to reach its June 8 high, while the market capitalization weighted S&P 500 has outpaced its June 8 high by about 200 points, which was largely driven by tech stocks. See chart “S&P 500 vs Equal Weight S&P 500” for details.

While most stocks have recovered to a certain degree since the height of the Covid-19 crisis in March of 2020, tech shares have led the recovery and even managed to grow in excess of the market. This underscores that this has been a narrow recovery, which has been largely driven by tech street, rather than wall street.
 
Volatility On The Rise
 
The VIX volatility index is currently at a level of 31, and thus well below its all time high of 87 set on March 16, 2020 when the Covid-19 crisis was at its high. However, compared to the development of the S&P 500, it is moving into a worrisome direction.
 
Since June 11, 2020 the level of the VIX volatility index has been on a steady decline. Given that the S&P 500 index was going up during that period the VIX’s level development followed general expectations – during a bull market volatility levels decrease as investors feel less pressure to sell.
 
This period has come to an end. Over the past few days, the direction of the VIX’s level has changed from down to up. While the S&P 500 continued to register gains or held steady, the VIX level increased sharply to the current level of 31. See chart “Volatility Increase Despite S&P 500 Gains” for details.

One interpretation of the sharp increase of the VIX level is that market participants are concerned that the market is overdone and that current price levels are unsustainable, and thus, ready for a correction.
 
Given that the market has had a big run over the past couple months, it could very well be that when we hit the next economic bump in the road, the reaction of investors is more likely to send the market into a tailspin.
 
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