Volatility often soars when the economy is facing turbulence.
And a week ago, the CBOE Volatility Index, also known as the VIX, surged to its third highest level in history.
The only other times the VIX rose higher were the 2008 financial crisis and 2020’s COVID crash.
The VIX measures “implied volatility” on the S&P 500. In other words, it reports how much everyone expects the S&P 500 to swing in the near future.
When things look bad, the VIX tends to jump and stay elevated.
So, the recent spike in VIX signals the potential for economic trouble ahead.
And we can watch for additional clues from a key market sector…
The Canary in the Coal Mine
Experts keep debating the reasons for the recent sell-off and what it means for the economy.
But I recommend watching the high-yield bond sector.
Much like the canary that would warn miners of danger, these bonds can offer an early warning signal.
You might also know high-yield bonds as “junk bonds.” Companies with poor credit ratings issue them.
These companies are of lower financial quality. They typically carry high debt levels on their balance sheet. Or have low profits relative to their interest payments.
In other words, they’re at higher risk of defaulting.
As a result, these companies have to offer higher yields on their bonds to tempt investors.
These high-yield bonds can give us a picture of what’s really going on behind the scenes in the economy.
And we can catch a glimpse by looking at the demand for these bonds – specifically, the “spread.”
The spread is the cost for these risky companies to issue debt compared to something safer like a U.S. Treasury.
That spread fluctuates depending on the outlook for the economy.
If things look good ahead, spreads fall to low levels. Investors aren’t demanding much extra compensation to lend to risky companies.
But when spreads start rising, it’s a sign that investors are growing anxious about the economy. They demand extra payment since the risk of defaulting grows.
Spreads have a good history of providing an early warning when a recession is around the corner.
For example, look at the chart of spreads below, heading into 2008’s financial crisis:
The blue line is the spread, and the shaded area on the chart is the recession during the 2008 financial crisis.
You can see that spreads started rising well before the crisis hit. And higher spreads are often a leading indicator of trouble.
So, what’s this signal telling us now?
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Troubling Times Ahead?
There was a lot of noise caused by surging volatility last week. And spreads delivered a warning too.
Take a look:
The chart goes back three years.
Spreads started rising into 2022. That’s when we had two consecutive quarters of negative GDP growth.
Then things calmed down, and spreads pulled back to low levels.
But we saw a recent surge in spreads as stock market volatility picked up.
High-yield investors are growing more concerned about the economic outlook.
I don’t want to overstate things. It’s not clear yet whether we’re in a recession or simply getting closer to one.
And maybe this turbulence will fade into calmer waters in the months ahead.
But enough signals are lighting up that I’d recommend caution. And maybe take some steps to protect your capital if you’re heavily invested in the stock market.
I suspect we’ll need to brace for more volatility ahead.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
P.S. While it’s worth being cautious, volatility isn’t something to be afraid of.
As traders, we can often use it to our advantage.
For example, just this past week, we’ve brought in gains of 54.4%, 121.4%, 34%, 15%, and 12% by trading options in my Opportunistic Trader advisory.
And the beauty of options is that you can profit whether the market goes up or down. If you took part in any of these gains – or would like to learn more – reach out to feedback@opportunistictrader.com.