This complimentary article from Options Profits was originally published on May 29. Don't risk missing over 40 options trade ideas every week, educational content, exclusive commentary and webinars from over 15 experts. Click here for more information and a 14-Day Free Trial.There has obviously been a decent amount of worry about what's going on in Europe. If not for our friends across the pond, I think the S&P fundamentally should be trading above 1400 and the market should be creeping higher not lower. That said, for the S&Ps to still be up on the year while Europe gets slaughtered is somewhat impressive. Maybe the market is in better shape than we think and a rally is at hand?
Looking at the stock market and ignoring bonds to determine the health of U.S. markets is a bit like buying a car based on looks alone. If the stock market is the U.S. exterior, the bond markets are the engine that really makes the markets work.
Take a look at this chart. If one were to quickly glance at it, they would think it was CBOE Volatility Index (VIX), since it peaks every time the market drops and craters at market highs.
It is not VIX, it is a 10-year weekly chart of iShares Barclays 20+ Yr Treas.Bond (TLT) through October 31 of last year, the TLT is the ETF that represents long term US debt (more than 20 years to expire). I illustrate this point to show how VIX and bonds are similar instruments. They are both what I would classify as insurance vehicles. The VIX represents that cost of insurance via S&P options, while the bonds are a safe haven investment for banks and funds.
If we zoom in from 2007-October 31 2011, you can see how similar they in movement. What the trader will notice is that typically the VIX moves sooner and in greater magnitude.
The TLT selling off typically signals that any major turmoil is ending. If a trader bought stocks when the TLT sells off from its peaks, rather than VIX, you would typically be buying pretty close to the bottom. This pattern persisted for the last 10 years. The two move so closely together that the difference of TLT-VIX almost always lands in the 70s, because when TLT is below 90, typically, the VIX is also below 20, and when TLT is above 120, the VIX is typically 40. There are rare occurrences on VIX pops where the spread falls below 70, and typically at the end of a financial crisis the spread threatens 80.
Then, something changed. Since the end of the last market turmoil in December of 2011 something strange happened, the VIX sold off, but the TLT did not. The spread between TLT and VIX has widened and widened. Where in every other crisis the spread should have stretched to near 80 and then eased back to 70 or so, the VIX has eased, bonds have not.While certainly some of this is "Operation Twist" affecting the spread, I think something else important has also changed. Money is flowing out of Europe and into U.S. debt. The big money NEVER moved a chunk of its cash back into the markets (something else that makes this rally so remarkable). Yet, the equity markets have never priced in the major moves that the bond markets are pricing in. To put it simply, TLT is priced like the S&P is in a crash, while S&P options (as measured by VIX) are priced just about at the long-term mean of the market.
Something has to give. Either the bonds have to come in or the VIX needs to explode. The VIX had been on a consistent downtrend throughout the year (and I still think it will be going much lower by year's end).