Another Sign That A Correction Is Imminent

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Includes: BXUB, BXUC, CRF, CVOL, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVOP, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SVXY, SYE, TALL, TNA, TQQQ, TVIX, TVIZ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USA, USSD, USWD, UVXY, UWM, VFINX, VIIX, VIIZ, VIXM, VIXY, VMAX, VMIN, VOO, VTWO, VV, VXX, VXZ, XIV, XVZ, XXV, ZIV, ZLRG
by: Macrotheme Capital Management LLC

Summary

VIX F1-F2 Contango is near 0%.

Most recently, when these indicators turned negative, we had a correction.

The trend of falling VIX Contango started on March 13th.

Straight to the point: the VIX Term Structure is flashing a warning sign that a correction is imminent. See the chart below:

So, what do we get from this chart? Specifically, we are looking at the percentage difference between the front month futures contract on the VIX (F1), and the next month futures contract on the VIX (F2), or the F1-F2 Contango.

As you can see, right now the difference is near 0%, 0.74% to be exact. But, if you look at the recent history, every time this indicator drops below 0%, we had a stock market correction.

Date Frame Lowest value of VIX F1-F2 S&P 500 Correction
Nov 2016 -1.8% -2%
June 2016 -2.6% -5%
Dec 15-Feb 16 -9% -13%
Nov 2015 -1.1% -4%
Aug 15 - Oct 15 -11% -11%
July 2015 -0.8% -3%
Dec 14-Jan 15 -13% -4%
Oct 2014 -8.3% -6%

Why does this happen? Specifically, the VIX index reflects option prices, and it's particularly sensitive to put option prices. Thus, as investors increasingly buy put options, the VIX rises. Why do investors buy put options? Likely either to speculate the downside move, or to hedge the long positions in their portfolios. More importantly, to lower the cost of the speculative trade or the portfolio insurance, investors prefer to buy short-term put options, which increases the value of the front month VIX futures contract, relative to VIX contracts that expire later. As a result, the VIX Contango inverts (aka backwardation).

So, it looks like investors have been expecting a correction and have been increasingly buying short-term put options to hedge or speculate. We have seen the trend in falling VIX contango (NYSEARCA:VXX) since March 13th, which is about 3 weeks lead time during which the S&P 500 (NYSEARCA:SPY) stayed flat.

Thus, based on the VIX F1-F2 indicator, it is possible that a stock market correction is imminent. The question is how big? It really depends on the trigger that causes the correction, as well as the subsequent events. As I mentioned last week, the meeting between the US President Trump and the Chinese President Xi Jinping could be a trigger if it starts the protectionist rhetoric, in addition to the fading hope of the Trump fiscal stimulus. Yet, at this point, nobody can predict the subsequent events, and the depth of correction (or whether it's a beginning of a new bear market).

However, based on recent evidence, the correction can be anywhere from a 2% minor dip, to a 13% major correction. My best guess would be that the S&P 500 would correct to about the 200-day moving average at around 2,200, which would be a 6-7% correction from the current levels. This is strictly an opinion based on technical levels.

Having said that, we could also get positive news from the Trump-Jinping meeting, in addition to a surprise compromise on healthcare reform. Needless to say, the Trump rally would continue within this scenario, and the VIX Contango would widen. Nevertheless, beware, the VIX F1-F2 Term Structure at this point is flashing a warning sign.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.