S&P 500 faces increased volatility due to Fed signals, US midterm polls

Zane Aw Yu Xuan

THE broad-based S&P 500 staged a double-digit relief rally of over 18 per cent spanning two months - from 3,636.87 points in June to the recent high of 4,325.28 points in mid-August. That rally was driven by signs that the inflation rate was starting to roll over and hopes that the Federal Reserve would slow down the pace of interest rate hikes.

However, those bets are unwinding and we could see S&P 500 volatility increasing after a period of calm.

At the Jackson Hole Symposium 2022 held in Kansas City from Aug 25 to Aug 27, Federal Reserve chairman Jerome Powell gave a “Don’t fight the Fed” address where he was direct in his remarks that there would be no pivot until inflation is tamed and the Federal Open Market Committee (FOMC) will “use their tools forcefully” to bring inflation back to its 2 per cent goal to achieve price stability, while cautioning about “some pain to households and businesses” in the process.

Additionally, he hinted at maintaining a restrictive policy stance where the central bank would continue to hike interest rates to tame inflation.

Looking at the S&P 500 Index, the relief rally brought it back to the 4,300 level which coincides with the 61.8 per cent Fibonacci retracement level using the swing high of 4,637.30 points in late March and swing low of 3,636.87 points in mid-June this year. However, the recent pullback created a bearish crossover signal on the Moving Average Convergence Divergence (MACD) technical indicator which signals possible downside for the index to head lower towards the 3,900 or 3,600 levels.

The S&P 500 Volatility Index also points to an upside in volatility. At the height of the rally in August, the fear gauge retested the support region at 18-20. It has since rebounded to the 50 per cent Fibonacci retracement level at 27, with the swing high of 35 in June and swing low of 19 in August this year as points of reference.

Further spikes in volatility could lift the gauge to the resistance level at 35. The S&P 500 Volatility Futures also signals that volatility is expected to rise over time. It is currently in contango, a situation where futures contracts trade at a premium to the spot price resulting in an upward sloping forward curve. At the time of writing, volatility futures due in September, October, November and December 2022 are priced at 26.30, 27.35, 27.65 and 27.65, respectively.

There is yet another potentially ominous sign that the stock market is heading into the riskiest month of the year – September.

The S&P 500 historically posts the year’s weakest returns in September, where it has averaged a 1 per cent loss in the month dating back to 1928. Additionally, this is a midterm election year where markets have exhibited unique risk profiles caused by election uncertainty translating directly into higher market volatility, especially true in the months leading up to the polls.

Since 1970, the S&P 500’s annualised volatility has a median standard deviation of 15.0 per cent in midterm election years, which is notably higher than the 13.0 per cent observed in other years.

Despite all these potential warning signs, the silver lining for investors is that after these bouts of volatility, markets tend to rebound strongly in the subsequent months. Since 1950, the average 1-year return following a midterm election is 15.1 per cent, more than double that of other years which stands at 6.8 per cent.

To conclude, it is important to be mindful that every individual year is different and investors should not let the noise and uncertainty generated by US midterm elections be a distraction from the fact that long-term equity returns are generated by the value of individual companies over time. Hence, prudent investors should look past short-term spikes in volatility that elections can bring and maintain a long-term focus.

The writer is research analyst at Phillip Securities