Why credit spread matters

Credit spread, the difference between risky bonds and risk free treasuries is a good indicator of investor risk tolerance. Widening credit spread indicates that investors are becoming more risk averse and are seeking safety in treasury bonds. This sentiment is reflected in the stock market. Figure 1 (top panel) shows the correlation between changes in credit spread and SP500 price. The correlation is not perfect (they never are) but this is about as good as one gets in finance.

Figure 1: Correlation between credit spread changes and SP500.

Periods of widening credit spread (red line on bottom panel) can be very risky for stock market.  This indicator alone is not sufficient in avoiding all market drops and it has given a few false warnings. Where it has worked big time is in avoiding large draw downs in 2000 and 2008. This indicator has also worked well since 2009.

Currently (11/25/2014), the credit spread is giving another warning. Combined with lofty valuations, the caution is doubly warranted.