The Two Warning Indicators for Stock Market Volatility

Chris Perras: Hey, I’m Chris Perras, Chief Investment Officer at Oak Harvest Financial Group. We’re an investment management, retirement planning advisor located here in Houston, Texas. Welcome to our November 5th Stock Talk, Keeping You Connected to Your Money.

This week, we’re going to cover just two topics, both related to volatility. One shorter-term and one longer-term. Viewers, neither of these indicators are directly equity-related, but they have been, in the past, great warning indicators of increased future volatility in stocks.

One is a very good near-term warning indicator, usually helpful for two to four-week periods. The second is farther off early warning tool. What’s most interesting is that both these indicators are good to use into the bond markets first, and then those views usually foreshadow movements in equity markets over time. Right now, in the words of actor and rapper, Will Smith, both are showing a period of getting jiggy with it, which is layman’s terms is code for more volatility coming down the line.

We’ve discussed both tools in the past two years on separate podcast segments but both tools now are coming into view at roughly the same time. Here it goes. The first is the MOVE Index. We’ve discussed this index multiple times over the last few years, usually around periods of very fast and gut-wrenching but brief downdrafts in equity prices.

The MOVE Index is the US long-term treasury markets equivalent of the VIX Index. It’s a calculation of shorter-term treasury bond market volatility while the spot VIX is the same for short-term equity volatility. Remember, these are math calculations, not tradeable indexes. Right now the MOVE Index is trading at level near 70 to 80. This is near its highest level since the COVID panic in March of 2020 and before that way back in September of 2019.

What this is saying is that treasury investors are worried about the shorter-term risk around Fed action through the next, say, 30 days. If I look at a month or two, this doesn’t really bother me as I think our treasury bond markets will calm down and adapt, and adjust to our Federal Reserve’s policies over times. What does concern me, say over the next two weeks, is that this measurement has historically led brief but sharp moves down in equities as hedge funds and people running leveraged portfolios are forced to sell their stocks.

We’ve discussed this dynamic in the past, but I’ll review it for new viewers. Why and how does this happen? When you run a leverage fund as a hedge fund or another active manager, you always have to post collateral to backstop or guarantee your leveraged investments.

Your prime broker looks at the safety of that collateral you were posting as well as its own volatility. This is the denominator used in calculating your leverage ratio. Being backed by the full faith and credit of the US government, treasury bonds are usually thought of as risk-free as any asset can get.

Being that there are massive markets for US government bonds, these markets are usually some of the least volatile markets in finance. Given this, they’re widely used as collateral backing leveraged trades. Whatever the hedge fund or other investor decides to use the borrowed money to invest in, be it other bonds like junk bonds or dividend stocks or MLPs or even growth in price stocks, becomes the numerator in this leverage ratio.

Prime brokers and other lenders measuring risk exposure think constantly adjust their exposure as a trade-off between the dollars they will lend you and volatility. Unfortunately, when your denominator is, say, treasury bonds, which is supposed to be one of the most liquid and least volatile in the world, starts moving at a fast price, the leveraged investor has no choice most often forced by their prime broker, in this case, who is also their lender, but to sell down their investment portfolio, which is the numerator in their leverage ratio.

When you see those straight-line moves down on Friday afternoons into the close or Monday mornings at the open, you can generally bet those are the margin clerks forcing leveraged investors to sell regardless of price.

Given the current signaling of the MOVE Index at the rapid 8% run-up in the S&P since the October load, it wouldn’t surprise us if there’s a short-term pickup in equity volatility from here into November options expiration in a few weeks. The second bond market warning indicator is one that historically provides an investor a much longer-term runway, making tactical moves in reducing risk if one feels compelled to do so.

We’ve talked about this one as well before. This is the junk bond indicator. You can look at junk bond credit spreads if you want to. A credit spread is how much a company or junk bond credit or say a pristine triple-A credit is paying its bondholders relative to the comparable US government treasury. Since junk bond companies are leveraged with debt so highly, their junk bonds tend to trade directionally with their equity.

When the economy slows down, junk bond credit spreads widen because the increased risk that you won’t get all your money back as this risk increases the price of a junk bond declines. For this indicator, I’m going to keep it simple and just use the price of the JNK junk bond ETF as representative of a high yield or junk debt.

Yes, purists will likely heckle me because I know this isn’t exactly a credit spread. I’m going to keep it simple here because I’m most interested in price momentum as an early warning indicator. One can see from the chart of the JNK ETF that the price action is starting to very closely resemble the pattern that transpired in the fourth quarter of 2017.

To me, this was one of the earliest warning signals back in the fourth quarter of 2017 that 2018 was not going to be a lot of fun. Sure enough, after the blow-off run of stocks into January into the Trump tax cut, equity markets peaked and experienced a fast and gut-wrenching drop, quickly retreating all the way back to its early November 2017 levels. The current pattern looks a lot, throughout 2021, in equity, it closely mimics the second half of 2016 through 2017. We continue to believe that this pattern holds into late January 2022 as it did in 2018, given the continued rotations in the market, and sectors that are working.

With only two months to go in 2021, the risk of a minus 10% or slightly more move, or correction from still materially higher levels from here in mid-first quarter of 2022 is growing. For now, though, it still looks and acts like a bull market for equities, albeit having exited the seventh stretch.

Our view is that large-cap technology stocks and growth in any price should lead an aggressive fourth quarter rally into late January of 2022. From there, it’s likely to be a replay of our first half 2020 outlook, which was Curb Your Enthusiasm.

At Oak Harvest, we think our clients are best served by helping us help them with their future needs and risks instead of dwelling on the past. Our forecasting is far from perfect, but we’d like to keep you up on what it’s saying about an uncertain future not rehashing an already certain past.

At Oak Harvest, we’re a comprehensive financial planning advisor located in Houston, Texas. Give us a call to speak to an advisor and let us help you craft a financial plan that meets your retirement goals. Call us at 877-896-0040. We’re here to help you on your financial journey. I’m Chris Perras, blessings and have a great weekend.

Voiceover: All content contained within Oak Harvest Podcast expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable when created, but any cited data, indicators, statistics, or other sources are not guaranteed. The views and opinions expressed herein may change without notice.

Strategies and ideas discussed may not be right for you. Nothing in this podcast should be considered as personalized investment, tax, or legal advice, or an offer or solicitation to buy or sell securities. Indexes such as the S&P 500 are not available for direct investment and your investment results may differ when compared to an index. Specific portfolio actions or strategies discussed will not apply to all client portfolios. Investing involves the risk of loss and past performance is not indicative of future results.