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3 Takeaways
The S&P 500’s drop below its 20-day moving average has likely triggered selling activity from systematic trend-following funds (CTAs).
Rising realized volatility—particularly the inversion between 1-month and 3-month measures—could prompt additional selling from volatility-control funds.
Elevated dispersion and constituent-level volatility suggest continued instability, with possible downside pressure persisting until these volatility metrics normalize.
Fully Edited Transcript by ChatGPT
The S&P 500 fell about 2.7% on Friday, continuing the pullback we discussed in Thursday’s and last weekend’s videos. The market had become overcoiled from a volatility standpoint, and today we’ll revisit where we stand. To begin, the index dropped below its 20-day moving average, which can trigger selling from systematic funds—particularly CTAs (Commodity Trading Advisors).
For those unfamiliar, CTAs are trend-following or trend-chasing strategies. When the 20-day moving average starts to roll over, these funds typically shift into selling mode, just as they become buyers when it turns higher. As long as the S&P remains below that 20-day moving average, systematic funds are likely to stay net sellers, which is an important factor to keep in mind.
We also saw three-month realized volatility rise from its previously low levels. This matters because when one-month realized volatility climbs above three-month realized volatility, volatility-control funds can also be triggered to sell. These mechanical forces may be contributing to the current wave of market weakness.
Before the decline, three-month realized volatility was around 8%—a level previously seen only in January 2020, October 2018, and December 2007. Each of those instances preceded significant volatility spikes and notable market drawdowns. Historically, such extremely low realized volatility tends to be followed by violent market moves. The recent setup appears similar, suggesting we may be at the beginning of another meaningful equity reversal.
Back in 2014, we saw a similar setup that ultimately led to a relatively muted outcome, but that was the exception. From a volatility standpoint, we had all the warning signs that the market was overstretched—it was just a matter of when a sharp reset would occur. The remaining question now is how deep that reset will be.
The dispersion index, which tracks performance differences between stocks, rose sharply on Friday to nearly 39—a very high reading. This indicates that while AI and technology names have continued to outperform, the rest of the market has lagged. For context, the S&P 500 fell 2.7% Friday, while the equal-weighted S&P (RSP) dropped only 2.25%. That spread reflects the elevated dispersion across market sectors.
Constituent volatility—the average implied volatility of individual S&P 500 components—also remains high, even though the VIX itself is only moderately elevated. On Friday, the VIX rose to around 21 after sitting near 16.5 earlier in the week. The gap between the VIX and constituent volatility is historically large, implying that either the VIX needs to rise further or individual stock volatility must decline to normalize the spread.
As earnings season approaches, constituent volatility typically falls as earnings uncertainty resolves. Leading into earnings, implied volatility usually rises—this dynamic supports the implied volatility dispersion trade, where investors go long volatility on individual stocks while shorting index-level volatility. That trade has been a tailwind for equities recently but could come under pressure if broader market volatility persists.
Taken together, these indicators suggest that the selloff may still have room to run before volatility metrics normalize. Systematic flows could add to downside pressure if weakness continues into next week. We cannot rule out a deeper decline resembling past volatility-driven corrections, such as late 2018 or early 2022.
From a technical perspective, support levels to watch include the 6475 region, followed by 6240, with additional gaps lower at 6000 and 5700. These may act as downside targets if selling continues.
Given that the VIX 1-day index spiked to 25.7 on Friday, we may see a short-term volatility reset Monday morning, potentially giving equities a brief boost. However, as long as the S&P 500 remains below its 20-day moving average—currently near 6660–6670—any rallies are likely to face renewed selling from systematic funds.
Defined Terms and Jargon by ChatGPT
20-Day Moving Average (20DMA): A technical indicator showing the average closing price of a security over the past 20 days, often used to gauge short-term market trends.
CTAs (Commodity Trading Advisors): Systematic, trend-following investment funds that buy or sell assets based on technical indicators rather than discretionary analysis.
Systematic Funds: Algorithmic or rule-based investment strategies that react mechanically to market signals such as momentum, volatility, or trend changes.
Realized Volatility: The actual measured volatility of an asset’s returns over a specific period, reflecting how much prices have fluctuated historically.
Volatility-Control Funds: Funds that adjust their exposure to equities based on market volatility, reducing exposure when volatility rises to manage risk.
Dispersion Index: A measure of how differently individual stocks move relative to the overall market; high dispersion means large performance gaps between stocks.
Constituent Volatility: The implied volatility of the individual stocks that make up an index, often used to assess risk at the component level.
VIX (Volatility Index): A real-time index representing the market’s expectations for volatility over the next 30 days, based on S&P 500 options prices.
Implied Volatility Dispersion Trade: A market-neutral strategy where traders go long volatility on individual stocks and short volatility on the index, profiting from differences between the two.
Volatility Reset: A short-term normalization in volatility metrics following a sharp move, which can lead to brief market rebounds.
Disclaimer
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