Option Market on High Alert for CPI Event Following Wild Week of VIX Fluctuations

As Wall Street braces for a pivotal consumer price index (CPI) report this week, traders are hedging their bets for continued turbulence in the market. The focus is squarely on whether the incoming data will provide the Federal Reserve with the impetus to commence rate cuts at its September gathering.

Despite the S&P 500 clawing back from a 3% drop earlier last week, the recovery doesn't seem to have convinced options professionals.

In the tumultuous trading that gripped Wall Street last Monday, the Vix surged to 65.73, its highest peak since the COVID-19 induced spike and the second-highest since the late 2008 financial crisis. While the VIX has experienced 11 significant weekly spikes above 45, only the ones during the 2008 financial crisis and the 2020 pandemic saw the index close the week above this level, alongside substantial declines in the S&P 500. This pattern, according to Bank of America's technical strategists, was not replicated last week as the VIX retreated to 20.37 by Friday, indicating a semblance of stability returning to U.S. equities.

On the other hand, the long-term outlook is brighter. Thirteen weeks after a VIX spike above 45, the S&P 500 is up 80% of the time, with average and median returns of 5.46% and 5.17%, respectively. One year later, the index has risen 80% of the time, posting average and median returns of 14.07% and 18.18%.

Reflecting on historical patterns, Goldman Sachs strategists have identified a notable correlation between market performance and sector movements. In instances where Cyclicals have lagged Defensives by more than 5 percentage points within a single week, a spike in worries over economic growth has followed. Such a divergence occurred last week, with substantial increases in both market volatility and correlations.

Following these episodes, history suggests that both realized correlations and implied volatility tend to recede slowly. Even three months post-event, these metrics often remain elevated compared to pre-event levels.

The future direction of the equity market now appears contingent on data releases that will either clarify or obscure the economic outlook. This will determine whether markets continue to be driven by macroeconomic factors or revert to the more micro-driven analysis prevalent in the first half of 2024.

Amidst macroeconomic and geopolitical uncertainties, analysts recommend investors adopt defensive strategies while seeking opportunities to purchase stocks that have been significantly impacted, including those in the healthcare and interest-rate-sensitive sectors. Analysts caution that if the S&P 500 index dips to new lows, a shift towards defensive stocks may be prudent.

Healthcare is often considered a safe harbor during market volatility, attracting investors when valuations in other segments appear stretched. Over the past month, the S&P 500 Healthcare Index has risen by approximately 3%, outperforming the general market's decline of over 4%. In times of economic uncertainty, stocks sensitive to interest rate changes, such as utilities, have also performed well. This year, the S&P 500 Utilities Index has seen an uptick of around 16%, exceeding the broader market's performance.