History favours being bullish on US equities – but take care

The VIX Index remains elevated at around 28.6 and US equities are down 0.5% before the cash market opens. US equities are down 16% from the peak in September and the smell of panic is spreading. The big discussion is whether the Fed made a policy mistake two days ago. The SaxoStrats team is of the view that it was most likely a policy mistake. The rate hike would have been justifiable, mostly to send a signal that the Fed is independent, but maintaining quantitative tightening on autopilot and putting too much weight on lagging economic data series were the two things that scared investors. As it is, the bleeding continues and frighteningly into a thin liquidity holiday period. So what can we expect from here? Well we have been crunching the numbers and here are our answers to confused and panicking investors.

It can get much worse

For analysis we broke daily VIX Index levels into deciles since 2 January 1990. We then isolated all the historic dates were the VIX Index was at the same level as the current decile. With the VIX Index at 28.6 it is currently in the ninth decile [24.1 – 28.6]. We then extracted the future returns 63 trading days into the future from that day. Aggregating all these returns provide us with historical sample returns. In order to compute the distribution of future paths we bootstrap* (with replacement) from the historical sample returns series future paths 63 trading days into the future. In total we simulate 50,000 paths.

The chart below shows the median (dark blue line) of these 50,000 paths and the ribbon spans the worst-to-best cumulative return in % at any given future time. It is clear that the potential outcome 3-month into the future from our current level in the S&P 500 is enormous. In the best possible scenario based on historical data we could be up 60% or down 39% (roughly the same log return).