Two of the best ways to track investor’s sentiment toward risk are to track the Volatility Index (VIX) relative to stocks and high yield bonds relative to stocks – and both have been flashing “warning” signs since early July. These are important to watch because stocks are usually the last asset class to react to weakening fundamentals.
The VIX
The VIX is something we’ve looked at a few times in the past but as a reminder, it measures the expected volatility of the S&P 500 over the next month. It can be thought of as the price investors are willing to pay to buy “portfolio insurance” in the form of options. The more nervous they are (also can be said as the less they trust a market rally), the more they’re willing to pay.
Here’s a chart of the S&P 500 (top chart) vs. the VIX (bottom chart) over the last year. When stocks are making new highs, it will usually be “confirmed” by the VIX making new lows. This is an indication that investors trust the rally and expect new highs still to come. This is evidenced during the first half of the year as the VIX made successively lower bottoms when the S&P 500 made new highs. However, you can see that beginning on July 3rd, the VIX has been registering higher lows each time the S&P rallies to a new high.
(click on the chart for a larger image)
Let’s look back at the past two market tops (2000 and 2007) to see what the VIX can tell us:
The VIX made new lows while the S&P 500 rallied through 2006. However, by the end of 2006, and through the early October, 2007 when the S&P hit its highest point, the VIX was making higher lows. This was as early warning sign to become a little defensive and ultimately proved to be a dire warning. It also works in reverse, offering a signal to buy when stocks make new price lows but the VIX doesn’t register new highs:
During the late 1990’s, the VIX moved higher and remained elevated for nearly 4 years before the stock market actually topped out. This shows that while a divergence between the VIX and the S&P 500 is a warning not to be ignored, stocks can also continue to climb higher for quite some time. This means we have to look at other indicators as well.
High Yield Bonds
High Yield bonds have been indicating a similar warning, not coincidentally, since July 3rd. The following chart is a ratio chart of the high yield bond ETF (JNK) relative to the 7-10 year Treasury ETF (IEF). We can use the ratio between the two as a gauge for investor’s willingness to take risk. When investors are willing to take more risk we’ll see high yield bonds outperform Treasuries (the chart will rise). Conversely, when investors are seeking relative safety, Treasury bonds should outperform high yield bonds which would be shown as the ratio price falling. As we can see, high yield bonds have been underperforming Treasury bonds rather significantly since July:
Now we can add the S&P 500 to the chart (blue line) for our illustrative example of comparing the two. You can clearly see that the two are highly correlated (moving up and down together), so which market is wrong?
All of you astute investors out there will probably recognize that the weakness in high yield bonds is almost solely attributable to the falling price of oil since energy companies now make up about 20% of the high yield bond index. So let’s change the ratio chart to show Investment Grade Corporate bonds relative to Treasuries vs. the S&P 500. While it’s not as dramatic, we can still an unwillingness of bond investors to reach for higher yields right now.
Like the VIX, weakness in corporate bonds (relative to Treasury bonds and stocks) is often an early warning to reduce risk in the stock market. The momentum of the stock market can often carry prices higher for weeks or even months, as we’ve seen lately, even though fundamentals might be worsening. Unless we begin to see these relationships reverse course, it would be wise to maintain a cautious position on stocks.
We began to see these divergences appear on July 3rd. That’s the day the US dollar began its steady climb higher creating a lot of weakness in international assets and commodity prices. The bond market is clearly telling us that the US dollar strength could lead to some “unexpected” economic weakness in 2015. It’s too early to know yet whether this will create some serious weakness in the stock market but it will certainly lead to a lot of volatility. For all of my clients, I’ll be detailing my outlook for the year ahead in my upcoming semi-annual letter and should have that out soon. I’ll post it to the blog a few weeks after sending it out to clients.
This will probably be my last post for 2014. Lauren and I are off to Pennsylvania for a few days to spend Christmas with my side of the family. Happy Holidays to all!
-Nick
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