Risk Signals: What Actually Works

The financial industry loves its risk-on/risk-off narrative. VIX spikes? Risk-off. Yield curve inverts? Risk-off. Credit spreads widen? Risk-off. But what does the data actually say? I analyzed 253 months from 2005-2025 across three classic risk signals. The results challenge conventional wisdom—particularly about the yield curve.

Here's the headline: when the yield curve is shallowly inverted (0% to -0.5%), SPY averages +1.45% monthly with a 75% win rate. That's the best regime in the entire dataset. The supposedly "ominous" inverted curve actually produces superior returns.

VIX, on the other hand, works exactly as expected. Low VIX environments deliver strong returns; high VIX environments struggle. But credit spreads? The relationship is messier than you'd think.

VIX: The Signal That Works

VIX is the clearest risk signal. There's a near-linear relationship between volatility level and forward returns:

Low VIX (<15) produces the best returns: +1.26% monthly with a 74% win rate. The sweet spot for risk-reward is VIX 25-30, which has the worst average returns (-1.12%) and lowest win rate (37%). Interestingly, VIX > 30 actually performs better than 25-30—likely because extreme readings trigger mean-reversion bounces.

The Yield Curve: The Great Deceiver

This is where conventional wisdom breaks down. The inverted yield curve is supposed to signal recession and market weakness. But the data tells a different story:

Why does this happen? Because the yield curve inverts before recessions—often far before. The actual drawdowns come later, typically after the curve has already normalized. Trading the inversion signal means selling into strength and missing the final leg higher.

Credit Spreads: The Noisy Signal

High-yield credit spreads are supposed to indicate stress in corporate bonds, which should spill over to equities. The reality is more nuanced:

The pattern isn't linear. Tight spreads are good (+1.16%), elevated spreads are also good (+1.11%), but wide spreads (5-7%) are the warning zone with only 51% win rate. Crisis spreads (>7%) actually show some mean-reversion potential, similar to extreme VIX readings.

The Multi-Signal Framework

What happens when we combine all three signals? I counted how many warnings are active each month (VIX > 20, curve inverted, spreads > 5%):

Zero warnings produces the best risk-adjusted returns: +1.13% monthly with 71.6% win rate. Two warnings crosses below the breakeven threshold with negative expected returns. The single 3-warning month (March 2020) produced an 8% bounce—extreme readings trigger extreme mean-reversion.

Sector Performance by VIX Regime

Different sectors respond very differently to volatility regimes. Here's how they performed in Low VIX (<20) vs High VIX (>=20) environments from 2010-2025:

Key findings: Financials (XLF) swing the most—from +1.28% in low VIX to -0.41% in high VIX. Gold (GLD) is the only asset that performs better in high VIX environments. Energy (XLE) also favors volatility, likely due to crisis-driven commodity spikes.

Current Status: All Clear

Where are we now? All three signals are below their warning thresholds:

With zero warnings, we're in the optimal "All Clear" regime. Historical expectation: +1.13%/month with a 71.6% win rate. This favors cyclicals over defensives.

Stocks for the Current Regime

Financials (Best in Low VIX)

Technology (Thrives in Low VIX)

Gold Miners (Hedge for High VIX)