The Seattle Seahawks’ come-from-behind, overtime victory over the Green Bay Packers in last Sunday’s NFC Championship Game was one for the ages.
The implausible comeback featured an abundance of memorable moments: a fake field goal, an onside kick recovery, a Hail Mary two-point conversion, a late field goal to force overtime, questionable play calling, visibly injured players gutting it out, and a winning touchdown to a receiver whose five previous targets had resulted in four interceptions.
Without a doubt, the ups and downs in this game sent fans’ blood pressures spiking across the nation.
Of course, erratic swings are also a fixture of the financial markets.
And as I warned would happen, the stock market’s volatility has increased in the past few months.
In fact, the volatility we’ve experienced in the S&P 500 Index is sending a warning signal that the market is about to have a heart attack…
The popular CBOE Volatility Index (VIX) is the options market’s primary gauge of equity market volatility. But it measures implied volatility, or expected future short-term volatility.
Instead, I want to examine realized volatility.
One percent-plus moves on a closing basis, up or down, may get news headline attention, but I want to include intraday volatility, as well.
For example, on January 13, the S&P 500 was up as much as 1.4% in the morning, but then faded into the afternoon and closed down -0.3%.
This bearish price action is what’s known as a reversal and is an underappreciated type of volatility.
The true range is a metric that basically measures the distance between the highest and lowest points during a specified time frame. Thus, the true range indicator can effectively capture intraday or intraweek volatility.
When we take an average of the true range for a trailing period, we arrive at the average true range (ATR). Traders use ATR to assess risk in their positions, but ATR is also a powerful tool that can seemingly predict the future.
The chart below shows the weekly true range averaged over a rolling three-month period for the S&P 500:
Think of this chart as the market’s cardiogram.
Based on this measure, the past few months have seen realized volatility rise to the highest level in nearly three years, indicating heightened stress and uncertainty.
Obviously, disruptive market events such as the credit crisis in 2008-2009 and the European sovereign debt crisis in 2011 are going to be accompanied by tons of volatility.
But when volatility rises at a time when the S&P 500 is near all-time highs, as is currently the case, we should take notice and stay alert.
Consider this analogy: When we’re watching a thrilling sporting event or exercising, our heart rate naturally rises. However, if our heart starts to race during a leisurely activity, then we should take that as a signal of underlying stress.
You’ll notice that the last time realized volatility rose significantly as the market made all-time highs was around October 2007, right when the bear market commenced.
I would categorize rising realized volatility as the second major sign that the stock market is forming an important peak, which is a process. The first was a widening of credit spreads for corporate bonds, which continues.
Oh, and gold seems to be getting a bit of a safe-haven bid, which we saw in 2011 amid the extreme volatility. The precious metal is up nearly 10% this year, showing resilience despite the strength in the U.S. dollar and broader commodity weakness.
Stay cautious, my friends.
Safe (and high-yield) investing,
Alan Gula, CFA