Should You Be Concerned About A Market Correction?

VIX and S&P500 in 2017
VIX and S&P500 in 2017.

US markets are making all time highs and volatility continues to get crushed. Are the increased concerns about a market correction justified, and should you be worried?

Seasonality is at it’s summer best (or worst, depending on your viewpoint) right now, volume is very low and ranges are tight. US indices grind out new all-time highs day after day and volatility is pushed lower and lower. Why then, if everything is so rosy, are more and more market commentators coming out and calling for a correction? More importantly, should you be worried and adjust your portfolios accordingly?

A question of market positioning.

One of the biggest worries in the market is the crowded short-VIX strategy, and how one-sided that positioning is. If you don’t what I’m talking about, an extremely fruitful strategy has been to short VIX futures contracts, rolling them each month and collecting a premium. As with most profitable strategies, they get crowded once people catch on.

The knock-on effect – let’s explore a scenario.

Imagine that the S&P500 actually sells off for some reason (you really need to use your imagination for that at the moment), there’s numerous concerns right now but let’s assume that something actually creates a risk-off environment. This could cause a spike in the VIX back to historical averages…which would be a 60-70% increase on today’s price. Just look on the chart above to see how quickly the VIX can move on a relatively small move down on the S&P500. If the VIX held those levels for enough time, shorts will be forced to liquidate, pushing the VIX higher and the S&P lower. You don’t need much of an imagination to see how something like that could get out of hand rather quickly.

Should you be worried?

It’s healthy to be somewhat skeptical and to plan for the worst, especially when it comes to your investments. If you’re long equities and are concerned about a correction, it’s very cheap right now to hedge your portfolio using options. It’s near impossible to pick when a correction will happen, however people who are much smart than you and me are giving the warning signs.

Note: Just as I was finishing up writing this article Trump came out and threatened North Korea. His words were serious and the market reached. Let’s see how the market takes this overnight and tomorrow.