Volatility is interesting as it is one of the best indicators of an impending market bottom but like so many other indicators is limited in helping to find a market top. I do however think it can help. At previous market tops we have seen a rise in volatility even as the market made new highs.
Right now volatility remains low though off its most recent lows. I would expect an increase in volatility while market breadth continues to weaken even as the market makes new highs going forward into 2011.
What happens now?
Here is the big picture as far as I am concerned in that volume will expand into the next major top as explained and expected by past market action:
Here are three charts on the yield curve that may have some long term merit in watching:
Time Frame: Intermediate Category: Monetary
Description
T-Bills are often viewed as an investment offering a "risk-free rate of return." Investors weigh the expected return of stocks versus the yield on these fixed income instruments. As T-Bill yields fall, investors have incentive to buy stocks seeking higher rates of return. Lower "risk free rates of return" combined with high expected returns on stocks often drive stock prices higher even during periods of weak corporate earnings and/or sluggish economic growth.
The Federal Funds Rate is the rate at which institutions make short-term loans to one another to cover temporary liquidity obligations. This market is also one of the Federal Reserve's avenues for adding or subtracting liquidity in the monetary system. Changes in the Fed Funds market can be influential in the future direction of interest rates.
Calculation & Significant Levels
T-Bill and the Fed Funds rate of change: The calculation is the same. The net change in yield over the last three months is divided by the yield three months prior. If the change is positive (rates have moved up) then the rate of change will be a positive number. When the rate of change is over 10% it is considered bearish. When it is less than -5% it is considered bullish.
Formula: (current yield - yield three months prior) ---------------------------------------- (yield three months prior)
Gauge Elements: Magnitude Updated: Weekly (as of Friday close)
Strategy
Historically, when T-Bill yields have risen by 10% in a three-month period it has been a warning signal for stocks. When T-Bill yields have fallen by 5% during a three-month period it has generally been favorable for stocks. Because the Fed has a less direct influence over the T-Bill market, it should be the focus of this indicator. When the Fed Funds confirm the action in the T-Bills it is a stronger indication of potential change in the stock market. In 1987, this indicator proved highly effective for those investors and traders who used it (they remained in stocks until just one month before the crash and then re-entered in November).
Long Bond 6-month Rate of Change
Time Frame: Intermediate Category: Monetary
Description
Long-term treasury bonds compete with stocks for investment dollars. Falling interest rates reduce borrowing costs, stimulate economic growth, and increase corporate earnings. This reduces the attractiveness of treasury securities and inducing investors to buy stocks. Historically, falling bond yields have supported stock prices, while rising yields have led to corrections.
Calculation & Significant Levels
Long Bond Rate of Change: The six-month rate of change in the long-term Treasury bond yield. A positive rate of change (rising yield) greater than 10% is bearish, and a negative 10% change is bullish.
Formula: (current long bond yield - long bond yield six months prior) ----------------------------------------------------------- (long bond yield six months prior)
Gauge Elements: Magnitude Updated: Weekly (as of Friday close)
Strategy
It is a major warning signal when rates have moved upward 10% within a six-month period. The investment climate has been generally favorable when rates have declined by 5% over a six-month period. Additionally, after a warning signal has occurred, it can be considered to be abated after the rate of change has dropped to below 10%.
Yield Curve Spread - Long Term Indicator
Time Frame: Long Category: Monetary
Description
The yield curve is the relationship between short-term interest rates and long-term interest rates. Normally, the yield curve is upwardly sloping reflecting higher yields on longer maturity bonds. Since the issuer of a bond is not obligated to pay the par value of the bond until maturity, the holder of the bond assumes the possibility of incurring a loss in nominal and/or "real" dollars. A nominal loss is incurred when the bond is sold at a capital loss. A "real" dollar loss occurs when the fixed income return is less than inflation. Longer maturities increase the possibility of incurring a capital loss and/or inflation diverging from its expected rate causing a "real" loss. Therefore, longer maturity bonds carry more risk which is normally compensated for with a higher nominal rate of return.
When the yield curve becomes inverted (short-term yields are higher than long-term yields) it is invariably bearish for stocks. An inverted yield curve may be caused by an unusually high demand for short-term funds (a near-term liquidity problem in government or business), a surge in short-term inflationary pressures, or a very restrictive monetary policy by the Federal Reserve. All three instances - liquidity problems, inflation and tight monetary policy, have negative implications for the economy and the stock market.
Calculation & Significant Levels
Yield Curve: The yield on the 30-year treasury bond minus the yield on the three-month T-Bills. When the yield curve spread is greater than 3.5% (very steeply upward sloping) it is bullish for stocks, and when the yield curve is negative (inverted) it is a bearish indication for stocks.
Formula: (Long Bond yield) - (T-Bill yield)
Gauge Elements: Magnitude Updated: Weekly (as of Friday close)
Strategy
The yield curve will always be a factor in the future direction of the stock market, but it is most useful as an indicator when it becomes either very positive or inverted. Historically, an inverted yield curve has been followed by a recession and falling stock prices. A steep upwardly sloping yield curve with a spread of greater than 3.5% usually supports higher stock prices.
My own chart that will update more often using the 30 year bond and 5 year treasury note:
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