The stock market faces heightened risk of another sell-off if the VIX fear gauge crosses 38, Fairlead's Katie Stockton says

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NYSE Trader
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  • US stocks could face another leg lower if the Cboe Volatility Index crosses 38, Fairlead Strategies' Katie Stockton said.

  • "The ~38 level is significant for the VIX, in that if it is broken, it would increase the risk of a capitulatory spike."

  • The VIX has yet to make a new high in recent months even as the inversely correlated S&P 500 falls to new lows.

Even after the S&P 500's year-to-date decline of 23%, investors should prepare for more downside if the stock market's volatility index crosses the 38 level.

That's according to Fairlead Strategies' Katie Stockton, who told clients in a Thursday note that another leg lower in the stock market is possible, and would likely be marked by capitulatory selling by investors if the VIX crossed the 38 level.

"The ~38 level is significant for the VIX, in that if it is broken, it would increase the risk of a capitulatory spike," Stockton said.

The VIX has yet to make new highs this year, even as the S&P 500 has made new lows month after month. That's a rare divergence given that the VIX and the S&P 500 are typically inversely correlated. And Stockton sees upside room for the VIX to hit that key level in the near-term.

"The VIX exhibits positive short-term momentum and has room to resistance (~38), which increases risk for the inversely correlated SPX in the near term," Stockton said.

Whether now is the time to buy stocks given this week's more than 8% decline, Stockton doesn't think so, and instead recommends investors remain hedged for further downside.

"The tape is clearly very fragile, and while short-term oversold conditions are widespread enough to foster a rebound in the days ahead, we would remain hedged," Stockton said.

Stockton's monitoring of the VIX is similar to DataTrek Research's recent note that a tradeable low in the stock market won't be generated until the VIX hits a two-standard deviation level.

"The VIX closed [Monday] at 34.0, well over 1 standard deviation (8 points) from the long-run mean (20), but not yet at the 2 standard deviation level (36) where the S&P 500 made its March lows," DataTrek co-founder Nicholas Colas told clients earlier this week. The VIX was sitting at 33.12 as of Thursday afternoon.

"We need to see more market stress before believing stocks are truly washed out enough to buy for a trade," Colas said.

VIX chart
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