By Popular Demand

  • Highest volatility in four years
  • Keep watching this JUNK…

Oy-vay! The volatility.

In a moment I’ll show you a chart that details just how wild the market has been in recent weeks.

But before I do that, it’s worth mentioning that, while volatility can be a pain in the backside, it’s not all bad news.

In certain circumstances, volatility can benefit investors.

It’s why the timing couldn’t have been better for the launch of our newest trading service, Options Trader.

You can find out more about it here in the specially produced ‘Cash on Demand Initiative’ video series.

Options Trader is a service run by my old pal, former Sydney Futures Exchange floor trader, Matt Hibbard.

I won’t say that Matt is cock-a-hoop about the volatility and the recent stock price slump, because he’s not.

But, where most folks see the slump as a negative and an excuse to get all doomy and gloomy, experience tells Matt that this is exactly the right time to introduce Aussie investors to an income-generating idea most people have never heard of.

Let me show you an example. Yesterday, the Aussie S&P/ASX 200 index fell 3.8%. If you own stocks (which you probably do), you could have lost $380 for every $10,000 in your stock portfolio.

That’s the downside of a volatile market.

However, if you knew about a strategy that could benefit from volatility, you would have looked at yesterday’s market in a whole different way.

For example, this particular investment went up in value yesterday, as the chart shows:

Click to enlarge
Source: Bloomberg

The day before, you could have ‘sold’ this investment for around five cents per share. Yesterday, you could have sold it for around 15 cents per share.

Volatility is good in this instance. And if you had sold it yesterday for 15 cents, you could have bought it back today, to close the position for around eight cents.

That’s nearly a doubler in one day.

Now, the strategy that Matt’s proposing doesn’t involve trading in and out each day. Matt’s approach is to make these returns (or hopefully better) over a two to three month period.

I know, this may seem confusing at first. And it’s not something I’d expect you to learn overnight. But that’s why we’ve put together the ‘Cash on Demand Initiative’ video series.

We had originally planned to limit the number of people that we would show the series to. But due to the overwhelming response (more than 8,000 unique registrations), we’ve decided to release the video series to all of Port Phillip Publishing’s 40,000-plus paying subscribers.

You should have received a link to the video series in your email inbox today. If you’ve missed it, just go here now to watch Part One. The other two parts in the series will be available tomorrow and Friday.

Highest volatility in four years

After yesterday’s slump, the market was much stronger today.

As I write, it’s up 1.9%.

It is just another day on the market.

The chart below shows just how volatile the market has been in recent weeks. The chart is of the S&P/ASX 200 Volatility Index:

Click to enlarge
Source: Bloomberg

You can see that volatility levels, as measured by the Aussie VIX, are at their highest since markets slumped in 2011.

Of course, the volatility is still a long way from where it was in 2008, when it seemed as though the entire world economy could collapse.

But it shows you just how fearful the markets are right now.

Put into context, the Aussie market is down nearly 1,000 points from this year’s high. The high point was 5,996.9 on 3 March. Yesterday it fell as low as 4,918.4. And right now, it’s trading around the 5,000-point level.

That’s a big move down from the peak. It amounts to around a 17% fall. Not that most folks realise that. Most folks concentrate on the rise or fall from the start of the year. Since the start of the year, the market is ‘only’ down about 7.5%.

It’s not that much better if you factor in dividends. From the start of the year, the S&P/ASX Accumulation 200 Index (which assumes the reinvestment of dividends) is down 5.7%. And since the high in April, the Accumulation index is down 15.8%.

So much for the idea that dividends help provide a cushion in a falling market. That doesn’t mean it’s a waste of time investing in dividend stocks. It just means that you need to think harder about what you do with your money, rather than just following the same old stale investing conventions.

Keep watching this JUNK…

On 4 August, when I warned of a potential market crash in September and October, I said that rising bond yields were one of the warning signs.

I wasn’t 100% right with my crash warning. The crash actually started the following day, on 5 August. That’s the kind of prediction that I could dine out on for years if I wanted to.

But I won’t. You know me…modest and humble to the last!

Anyway, one stock I’ve recommended watching closely is the SPDR Barclays High Yield Bond ETF [NYSE:JNK]. It trades in New York, and invests in high yielding (known as ‘junk’) corporate bonds.

The market believes that these bonds have a higher probability of defaulting. Their higher risk means that they carry a higher yield.

That doesn’t mean all ‘junk’ bonds will default. As a report from The Economist noted earlier this year:

Junk debt also looks a lot less like garbage than it used to. Contrary to its reputation, issuers are proving to be reliable payers, as a new study by Deutsche Bank shows. Since 1983 (the period for which Deutsche has data), the default rate for junk bonds has averaged 4.9%. But that disguises a big change that occurred after 2002. The average default rate from 1983 to 2002 was 6.9%; since then, the average has been just 1.5%. In this later period, the only year in which the default rate was above the long-term average, at 15%, was 2009, when the world economy was slumping.

This is particularly surprising given that the creditworthiness of issuers has steadily declined over time, as judged by the rating agencies.

I’m not completely sure why the folks at The Economist are so surprised by the lower default rate.

Perhaps they aren’t aware that interest rates have been at record lows for the past seven years.

Maybe they missed that whole thing about low interest rates forcing investors to shift along the ‘risk curve’.

By ‘risk curve’, I mean the fact that investors who need to earn (say) 5% per annum, and who previously could have achieved that from a bank savings account, now have to buy riskier assets to get the same yield.

Investors who could previously get 6% from blue-chip dividend stocks, now have to buy mid-cap or small-cap dividend stocks.

Investors who could previously get 8% from small-cap dividend stocks, now have to buy some other, even riskier investment.

It’s the same deal with bonds. Many government bonds (for generations, considered to be ‘risk free’) now pay negative yields.

That’s bad news for defined benefit pension funds and insurance companies, which relied on this ‘risk free’ interest to plan for long-term liabilities.

Now they have to buy higher risk bonds, such as state government or municipal bonds, or perhaps corporate bonds.

The reason I’ve suggested that you should closely watch the junk bond market, is that it will give you a clue about investor attitude towards risky debt.

The six-month chart of the JNK ETF shows you just what investors think of risky debt…

Click to enlarge
Source: Bloomberg

…they don’t think much of it at all.

Bond prices move inversely to bond yields. The chart above shows that junk bond prices are falling. That means junk bond yields are rising.

It means fewer investors want anything to do with these bonds. They want to get out of them. And even the higher yields aren’t enough to attract new investors.

Today, the JNK ETF yields 6.3%. A month ago it yielded 6.07%. One year ago, it yielded 5.87%. Junk bond yields are rising.

It’s one of the warning signs I told you to watch closely. If this trend continues, it could be confirmation that market volatility and bond yields are about to rise much further.

(Incidentally, I’ve added the JNK ETF yield into the new market data section below. You’ll find it in the ‘Selected Market Dividend Yield’ section.)