The relative performance of U.S. small market capitalization stocks and the CBOE Volatility index should move in opposite directions because they're essentially measuring the same thing in inverse ways – investor risk tolerance. But right now, the VIX is stable while small cap stocks drastically underperform the large cap benchmark. This might constitute a serious warning sign for equity investors.
The chart below shows the relative performance of the Russell 2000 small cap index and the S&P 500 by dividing the Russell by the large cap index. When the line is rising, small cap stocks are outperforming large caps. The CBOE Volatility Index, which uses options pricing to measure expected equity market volatility, is the other line.
Small cap outperformance (the rising black line) is a sign of increasing risk tolerance. It shows that investors are comfortable enough with market risk that they're willing to accept the higher risk of volatile small caps in search of larger returns.
The VIX does the same thing in the reverse direction. A rising VIX means option underwriters expect higher levels of market volatility and demand higher premiums to take on the added financial risk of writing put and call options.
From mid-2010 until January 2014, the pattern is what we'd expect. Russell 2000 outperformance of the S&P 500 showed rising investor risk appetite and the VIX, by falling, showed the same thing.
Things got weird after that. Small caps started to underperform badly, showing investors were becoming less confident, but the VIX stayed near all-time lows, suggesting investors were not only willing to add risk, but were becoming disturbingly complacent.
CBOE Volatility (VIX) Index vs Russell 2000 divided by S&P 500
SOURCE: Scott Barlow/Bloomberg
Market history suggests one of the two lines on the chart will jump higher in the coming weeks. A positive outcome for investors would be a return of confidence in the form of a small cap rally. That would make everyone happy.
A leap in the VIX would, on the other hand, be very bad news. For one, a rising VIX is almost always associated with broad equity market sell-offs. For another, the rising VIX is also associated with rising credit spreads – which means higher financing costs for everyone (including mortgage buyers) and steep losses for the hordes of investors that have been piling in to corporate bonds and other yield products.
Corporate profit numbers and economic data have been so mixed lately that I'm not making a prediction either way. But investors should pay careful attention to the VIX in the weeks ahead, taking at least partial profits if it climbs.
Follow Scott Barlow on Twitter @SBarlow_ROB.