With the US stock market’s correction in February still fresh on traders’ minds, Citi is warning of another such meltdown.
Stocks have since recovered all their losses, rallied to new highs, and extended their bull-market run to a record streak. But stocks are called risk assets for a reason — their volatility — and Citi’s equity trading strategy team is alerting clients on the conditions that are brewing ahead of the next plunge.
“Indeed, after flirting with ‘euphoric’ levels for the past 2 weeks, Citi Research Strategy’s Panic-Euphoria model finally tipped over the threshold this week [into euphoric territory], suggesting a 3x higher likelihood of negative SPX returns over the next twelve months,” Antonin Jullier, the global head of equity trading strategy, said in a client note on Wednesday.
He added: “This is Jan. all over again, minus XIV,” referring to the exchange-traded note that helped worsen the market’s selloff earlier this year. The ETN had profited when markets were quiet in 2017, but imploded as the CBOE’s volatility index, or VIX, spiked by the most ever in a single day on Feb. 5.
Strategists had warned about the ETN’s risk ahead of the market’s correction. But that’s not what Jullier and his team are raising red flags about now.
Their first concern is the return of an inflation scare.
Stocks initially became jittery on February 2 after the Bureau of Labor Statistics reported that average hourly earnings rose at the fastest year-on-year pace since the recession. Such news is great for workers. But to Wall Street, it’s an inflation signal, and implies the Federal Reserve can continue raising borrowing costs to protect the economy from overheating.
Coincidentally — and after Citi’s note was published — the August jobs report released Friday showed that wage growth hit a new post-crisis high.
Traders now have to also grapple with inflation that may stem from the US’s tariffs on its biggest trading partners including China, Jullier said.
The second reason for his team’s concern relates to earnings growth, the all-important catalyst of stock prices.
Stocks recently touched new highs partly because of corporate America’s strong second-quarter results, with more than 80% of S&P 500 companies topping analysts’ forecasts for profits.
However, they may not be able to sustain this momentum, according to Tobias Levkovich, Citi’s chief US equity strategist.
“The crucial question is where to from here,” he said in a separate note. He added that higher interest rates, a stronger dollar, and the absence of new tax cuts imply that it’s hard to extrapolate recent strength into a long-term pattern.
Jullier’s team further observed a trend that is mirroring its pattern before the February selloff: a shift in the correlation between the VIX and the S&P 500.
Their relationship is normally negative, meaning that the so-called fear gauge falls when stocks are rising. But in August, the relationship turned unusually positive as stocks surged — precisely what happened just before the February correction.
For traders who want to “hedge while it’s cheap,” Jullier offered some suggestions:
- Broad EM de-risking: Buy FXI Oct 40/44 strangle for $1.08
- Using the VIX complex: Buy 1×1.5 VIX Oct 15/23 and Sell VIX Sep 13 Put for $0.75
- US curve steepeners: Buy 1Y 2s30s ATMF Cap contingent on SPX < 95%