How High Will The VIX Go?

| About: iPath S&P (VXX)

Summary

The CBOE Volatility Index or VIX has been rising recently.

The U.S. elections, the U.S. Dollar Index and the Fed have been the main catalysts.

Equity valuations and geopolitical events could contribute to the rising VIX.

A long VIX or short equity market strategy can take advantage of rising volatility.

As the CBOE Volatility Index (VIX) has been making a series of higher lows over the past two months, momentum has been moving to the upside. Recent activity has resulted in VIX 15/16 levels, and a further sustained upside move appears to be the most likely scenario over at least the next month. In my previous articles, I have pointed to several factors that are likely to lead the VIX higher. And, while some of the dynamics have shifted, the broad landscape still points to further upside for the VIX.

U.S. Elections: The U.S. Presidential and congressional elections are less than a month away, and they have already been affecting markets. Historically, the month preceding elections is marked by higher levels of volatility, and this election season is no exception as volatility is on the rise. As a matter of fact, the relative cost of options implying a 5% market decline has recently risen to twice that of options that imply a market increase. This is the highest relative cost differential ever recorded, and it appears that it will persist at least until after the elections. If this happens, volatility can be expected to increase further.

The Dollar: U.S. Dollar Index futures have been on the rise for the last couple of weeks. With Brexit concerns weighing on the pound and the state of the European banking system hitting the euro, this move is to be expected. The problem with an increasing dollar is that it negatively affects corporate earnings, commodity prices and emerging market debt. As market consensus estimates are for corporate earnings to decline by 2.1% for the third quarter of 2016, a rising dollar is likely to further exacerbate a market decline.

Interest rates: It is widely expected that the Fed will raise interest rates during at least one of the two remaining meetings of the FOMC before the end of the year. While the market believes that a rate hike is unlikely at its November meeting due to its proximity to the elections, a December hike is widely expected. The bond market seems to believe there will be a rate hike before year end as evidenced by recent rising rates. If rates continue to move up, increasing volatility and declining equity prices are almost a certainty.

Valuations: Market equity valuations are stretched to put it mildly. Most equity valuation measures remain elevated compared to historical levels, and they could provide a further catalyst to increasing volatility over the next couple of months. I reference my usual set of valuation metrics - forward or backward P/E, Schiller P/E, market cap to GDP, and price to sales - to illustrate the premium valuation of the current equity market. Recent elevated volatility levels are likely to rise further, given current valuation extremes.

Geopolitical concerns: While markets have been able to shake off most recent global events, it is only a matter of time until something comes along and knocks equities down. There are several current factors that could worsen and spill over into the markets. Some of these include the Syria situation, rising tensions with Russia, ISIS and Iraq. This is not to say a new, unknown crisis couldn't come along as well. Black swan events are by their nature unpredictable, but they usually have the same negative implications for markets.

So the question is what can be done to protect your portfolio and/or take advantage of expected rising volatility levels. A long VIX portfolio allocation would be a way to hedge portfolio exposure and limit the equity losses associated with increasing volatility. A more aggressive strategy would be to short the equity market or go long VIX through ETFs or options. For equities, a short strategy is easily accomplished through many equity ETFs such as the SPY as well as through options. Some of the more common VIX-related ETFs that can be used for a long strategy are VXX, UVXY and TVIX. VIX-related options also can provide the desired VIX exposure while capping downside risk. For any strategy, I strongly encourage investigating the performance characteristics of any security being considered before putting on positions. These strategies are not for the novice, and a full understanding of the potential downside risks needs to be considered.

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Disclosure: I am/we are long VIX ETFS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.