Traders show more concern in bonds than stocks

Key points:

• The VIX has dropped more than 25% from its high
• At the same time, bond market "fear" has remained elevated, near 52-week highs
• Similar behavior preceded some significant declines in stocks, but those were the exceptions

Bond market fear nears 1-year highs as equity market fear drops

We saw on Monday that investors have picked up their hedging activity. One of those metrics was their willingness to pay more for protection against a major credit event.

An alternative measure of this concern, with a longer history, is option-adjusted credit spreads. Bond traders will cringe at this, but if we use CDX spreads or option-adjusted spreads as a sign of bond market "fear", they're just off their 52-week highs. But equity market "fear" via the VIX is down by more than 25%.

It's relatively rare to see these equity and bond metrics diverge for long. The chart below shows a 10-day rolling correlation between daily changes in the VIX and option-adjusted spreads. Over the past few years, it has spent 82% of the time in positive territory. The current reading is in the bottom 7% of readings.

A market clichè is that the bond market is smarter. We've looked at that from dozens of different directions over the decades, and there is no clear edge one way or the other. Sometimes, bond traders panic just as foolishly (in hindsight) as stock traders.

Similar bond vs. stock market "fear" showed gains for stocks...with a caveat

To see if there's anything to this current situation of elevated bond market fear while stock investors see easing concerns, the table below shows all similar days since 1997.

Several times, concern in the bond market was a good tip-off that stock investors weren't pricing in enough risk. Near the market peaks in 2000, 2007, and 2015, we saw a divergence like this, leading to large losses in the S&P 500. Most of the time, though, the S&P rose in the weeks and months ahead. Its median return was below average but still positive.

For the VIX, it was not a consistent enough signal suggesting it would spike. Over the next 3-6 months, the VIX rose after only 5 of the 14 signals.

What the research tells us...

With the market environment currently unhealthy, we're constantly looking for signs that the recent recovery from pessimism will fail. That's what unhealthy markets do. The rise in concern in the bond market is a potential tip-off that stock investors are too complacent, with some supporting evidence from prior peaks. But it has not been a consistent enough signal to suggest we dismiss the recent positives over a medium-term time frame.