In case you just got back from a long vacation, stock markets around the world were selling off sharply to start the week. While reviewing my emails, I came across an interesting article by Denise Chisholm from Fidelity Investments that may be of interest to my investors as part of their learning curve. At the time of writing this, the risk assets on my radar are trading higher.
Here is a section:
To be sure, the recession question is vitally important for investors. The 6-month periods heading into recessions have historically been some of the worst times to be in the market, with it often taking years for investors to recover. Non-recessionary pullbacks when the market corrects even though the economy continues to expand have historically been much less severe, with investors recovering in a matter of months.
While earnings have been giving some clues on economic fundamentals, I also like to look for signals in the market data itself. One key signal I noticed in the past week was the rapid rise in the VIX, an index of implied volatility that’s also a useful yardstick for the level of fear in the stock market.
While intuition would suggest that a steeper rise in the VIX signals a higher likelihood of recession, in fact the opposite has historically been true (perhaps a sign that extreme fear reactions in the market are more often overdone, compared with more moderate fear reactions).
I turned up an even stronger signal by comparing fear in the stock market with fear in the bond market, which investors often measure with changes in credit spreads. Credit spreads measure the amount of additional yield that investors demand in exchange for taking on credit risk, such as with high-yield bonds.
When investors become more worried about economic conditions, they demand more yield for taking on credit risk, so credit spreads increase. While credit spreads did increase in the bond market in the past week, they increased by much less than the jump seen in the VIX.
In other words, the stock market has looked much more worried in the past week than the bond market. Historically, more than 80% of the time, big discrepancies in those fear indexes like what we saw in the past week corresponded with a non-recessionary market pullback. In 100% of historical periods with similar dynamics in those indexes, the stock market went on to advance over the following 12 months (though past performance is no guarantee of future results).
To put it very simply, when the stock market panics but the bond market doesn’t, often the bond market turns out to be right. (Another old saying in investing is that sometimes, the bond market is smarter than the stock market.)