By Ian Davis | 17 June 2008
Throughout history, investors have fallen into and out of love with risk.
For example, in October 1998, investors were jumping at the chance to buy junk bonds at a measly 2.8% premium to Treasury bond yields. Then, by October 2002, the default rate on junk bonds was spiking. To entice an investor to take on the risk of a junk bond in late 2002, corporations had to offer yields that exceeded Treasury bond yields by more than 10%. In both cases, investment-rating companies rated the bonds similarly. So their risk of default should have been the same. Investors were just valuing the risk differently. In other words, investors become overly cautious during bear markets and overly daring during bull markets.
That's no surprise... But when investors panic, it creates inefficiencies in the market we can use to our advantage. So I wanted to figure out a way to measure exactly how 'serene' or 'panicked' investors are today. My "serenity index" tracks three measures of risk: the emerging-markets spread, the high-yield spread, and the "VIX" volatility index. Emerging-market bonds and high-yield bonds are risky assets. And how risky investors think they are is easy to quantify: It is simply their yield over a risk-free U.S. Treasury bond. The VIX, which measures the premium investors are willing to pay for portfolio insurance, is the most widely used measure of how worried investors are. Putting these three indicators together gives a fairly good picture of the market's mood.
Let's Take A Look At Today's Numbers
The Lehman Brothers Emerging Market Bond Index is yielding only 2.8% more than 10-year U.S. Treasury bonds. This is about half of its 15-year median of 4.5%. So investors today aren't worried about risky emerging-market debt. On the other hand, the Merrill Lynch High Yield Master II Index is yielding 6.18% more then U.S. Treasuries (way above the median spread of 4.5%). So investors today are worried about high-yield bonds. Finally, the VIX is currently 18.4% above its historic median level. This means investors are somewhat worried about risk in the equity market.
So investors may be wary, but they're not quite panicked yet. The following chart shows my serenity index versus the S&P 500 (I flipped the y-axis so the highs and lows line up).
Investors Are Pricing More Risk into the Market
But They're Not Panicked Yet
Click Here, or on the image, to see a larger, undistorted image.
The five blue lines show times when investors have panicked in the past. If you had bought an S&P 500 index fund on these panic extremes and held for just three months, you would have made an average 16.8%. And this indicator is consistent. You would have made money every time.
At worst, if you had bought in October 1987 (right after Black Monday), you would have made 10.3% in three months. And at best— if you had bought in November 2002— you would have made 19.4% in three months. As you can see, investors have become much less serene over the last 18 months... But they have remained relatively calm in the face of a weakening economy. When they finally do start to panic, we'll have a great opportunity for a short-term trade. If history is any guide, it will be a quick 16.8% in three months.
Good investing,
Ian Davis
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Normxxx
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