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The Market's Measure
market's measure

Geometry for Stock Investors

Triangle formation warns of a volatility spike.

See anything in the picture below? It charts the spread between the 10-year Treasury note rate and the S&P 500 dividend yield. While the spread’s been widening since the presidential election, there’s been a worrisome congestion area forming since April.

It’s that area—scribed by the red lines—you should be seeing. Why is it worrisome? Because of its shape. It’s a symmetrical triangle, a pattern usually predictive of an explosive breakout in the direction of the established trend. Emphasis on the word “usually.” There are times when a countertrend breakout occurs, heralding a reversal. That’s the worrisome part.

Keep that in mind because there are indications elsewhere that the risk of a downside break is increasing. But, let’s not get ahead of ourselves here. 

You’re probably asking yourself why you should even care about this spread. It’s simple: The spread is correlated with significant movements in the stock market. Generally, as the spread moves, so too does the S&P 500. To make sense of that, think of what has to occur for the spread to widen: Treasury yields must rise and/or stock dividends must fall. That signals flight from “safe haven” government paper to riskier equities. A falling or negative yield spread portends risk aversion as investors buy T-notes in lieu of stocks.

There are signs that capital is moving away from equities now. Just this week, in fact, a bearish diversion developed in the chart below. The graph’s right-hand scale denotes investors’ appetite for risk derived from a price ratio of the Invesco S&P 500 Low Volatility ETF (NYSE Arca: SPLV) over the Invesco S&P 500 High Beta ETF (NYSE Arca: SPHB).

So what to do? Well, first we need to sort out how much of this effect is seasonal and how much actually arises from conviction. After all, there’s still a cohort of investors who subscribe to the “Sell in May and go away” dictum. Volume typically dries up ahead of the Independence Day holiday as books are squared.

The week after the holiday—this week—will give us more clues. Keep an eye, particularly, on the option market for signs of a surge in put-and-straddle buying. 

The yield spread has been aiming for a target of 1.65 percent, but a downside breakout from the triangle has the potential to drag the spread down to levels not seen since last October. 

Brad Zigler is WealthManagement’s Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange’s (now NYSE Arca) option market and the iShares complex of exchange traded funds. 

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