Here is something on my mind lately. Why isn’t the market pricing in any risk to the new Covid strain that is gaining momentum? 

Delta is now the dominant Coronavirus variant in the U.S. The highly contagious delta variant now accounts for more than 51% of COVID-19 cases in the U.S, according to new estimates released by the Centers for Disease Control and Prevention.

Meanwhile, even though vaccines administered in the U.S appear to be highly effective— there are roughly 140 to 150 million people in the U.S. who remain unvaccinated. 

Today I’m going to dive into the market breadth, the volatility picture, and how Delta could impact trading. 

Digesting Risk

The market does not always price in the risk that is on the horizon immediately. While sometimes the reaction to threats can be immediate and vicious, for example, changing fundamentals or breaking news, the market needs time to digest Macro events.

Think back to the first Coronavirus outbreak in China in January last year. When news of the outbreak in China was known on January 27, the SPY gapped down but continued higher for 2 more weeks. This was despite the government in China shutting down not only Wuhan but also Shanghai. 

 It wasn’t until the first cases were reported in Italy and then in the U.S until the market began to price in risks to the U.S and global economies. What ensued was historical volatility. 

During those two weeks, as the virus spread, it was Earnings season in the U.S., and stocks such as NVIDIA CORP (NVDA) were breaking to all-time highs, the SPY was shrugging off any bad news, and TESLA INC (TSLA) had an epic short squeeze running from $500 to $1000.

Similarities to Today

As we enter another round of earnings season—NVDA is up 50% over the last two months. In addition, AMZN is up 10% the last two weeks— breaking out to all-time highs.  And the SPY and QQQ are shrugging off inflation fears. All while the spread of this new Delta strain is becoming prominent in the USA.

Is Volatility Ahead?

As euphoria starts to creep back into the market, it is now prudent to prepare for the possibility of increased volatility coming into earnings season due to this new virus strain because it appears that the market is pricing in 0 likelihood of any negative repercussions. 

However, that can change quickly. 

Considering the measure of market volatility VIX, we can see that it made new lows on Friday as the market broke out to all-time highs. However, for the first time in a while, it showed some relative strength. Even as the SPY was making new all-time highs, the VIX was also making new highs at the end of the day.

Often is the case; the VIX makes new lows as SPY makes new highs. What happened Friday is often an early sign of possible weakness in the market ahead. 

And on Monday, we got confirmation that Friday wasn’t merely a fakeout. Monday, we saw a continuation in strength in the VIX  and the SPY sold off for most of the session with a late recovery after midday.

Market Breadth 

What gives me added conviction in my thesis is that many stocks are not participating in this rally. As SPY and QQQ are making new highs, momentum stocks such as Beyond Meat ( BYND) and Palantir Technologies (PLTR) are no longer participating in the rally and are beginning to pull back.  IWM, the Russell 2000 ETF representing the small-cap Index, fails to break out with the large caps in SPY and QQQ’s.

For this breakout in the market to be sustained IWM needs to break out to all-time highs. It is showing divergence, which could be a sign of trouble ahead in the broader market.

Bottom Line

As the new Delta Coronavirus variant spreads throughout the USA, the market is not pricing any risk to adverse outcomes. Given the relative weakness in some market sectors that are not participating in the rally, I am preparing for the possibility of increased volatility ahead.