A, B, or C

The divergence between credit spread and stock market has been widely noted in financial media. Often weakening credit spread signals loss of risk appetite and impending correction in stocks. But not always. Note area A in the figure above. Credit market signaled steep decline that did not materialize. Usually, the stock market and credit market decline simultaneously as in B above. And then we have C where credit spread preceded steep decline in stocks.

So is the current decline A, B, or C? B is ruled out by comparison (stocks and credit do not move in sync). It does not look like A either: the credit spread increase has been prolonged and sustained lasting over 6 months. And this happens in the very mature bull market and with the backdrop of deteriorating financial news.

This leaves C: Credit is signalling steep losses for stocks in near future (next few months). 

Market peak of everything - evidence that the stock market has already peaked

The broad selling of the stock market continues. Is this just another dip or has the market already peaked? The overwhelming evidence suggests the latter:

1. The margin debt has peaked. The margin debt reached historic high of 2.7% of US GDP on February 2014. The margin debt peak has preceded the last two major stock market peaks in 2000 and 2008 by a few months.

Source: NYSE

 2. Value of equities relative to GDP peaked in Q2 2014. This indicator has not turned down decidedly but this may be just a matter of time.

Source: FRED

3.Similarly, the household allocation to equities reached high in Q2 2014 (22% of all household assets is in equities). The equity allocation has been higher only once in 2000. In other words, there is no cash on the sidelines; the households are all in.

Source: FRED

4. The inverse of credit spread peaked in May 2014 and has decidedly broken down. This has been a good leading indicator to stock market.

Source: FRED

5. Corporate profits as percentage of GDP (a proxy of profit margin) peaked in Q3 2013.

Source: FRED

6. The corporate cash flow peaked already in Q4 2011 and has not increased since.

Source: FRED

7. The major stock markets around the world are going down in unison.

8. As are the stock indexes in US.

In summary, there is overwhelming evidence that the stock market has already peaked. Given the excessive valuation, it is likely that the market may go down significantly over the next 6 to 12 months.

Signs of stock market top

There are currently quite a few signs that we are near stock market top:

1. Excessive valuation

The stock market valuation is above the historical norm. Q ratio is second highest in history. Shiller PE is over 27. When the market turns, the value conscious investors will stay away.

2.  Extreme bullishness

Even minor market dips are heavily bought. Cash allocations are low. Margin debt is high. Investor sentiment is extreme.

3. Final push/overshoot

Everyone wants to buy in a fear of missing out and no-one wants to sell. This can result in a final rapid price appreciation that stands out and makes the overvaluation just more obvious. Think about climbers reaching a summit and asking "now what?". The 10%+ price run a matter of weeks qualify as significant movement. 

4. Deterioration of market breath 

Healthy market moves in unison. Strong bullish tide carries all stocks. When this starts breaking down (more stocks making new lows, more stocks below long term moving averages), the market is about the hit an air pocket.

5. Rolling over of leading indicators

The unprecedented monetary stimulus has made leading indicators less useful in this business cycle. The current expansion is one of the longest and weakest. Looking OECD indicators, the global growth is continuously weak, near the stall speed. The US based private research company ECRI's weakly leading index growth is also negative.

6. Widening of credit spread

The credit spread, difference between high yield and treasury bonds is on the rise signaling risk aversion. This correlates well with stock market.

7. Money flows into defensive stocks (utilities and consumer staples)

This is the classical market timing method. The current bull market is a bit confused but utilities and consumer staples have been the strongest performers indicating defensive stance.

8. Increasing volatility and "nervousness"

Small daily movements become wider daily swings. The market leaders suddenly hit air pockets. Apple losing 5% intra day qualifies.

9. Emperor has no clothing moment

A wide spread recognition that something everyone already knows may actually matter. For example, everyone know in 2000 that valuation was high. Then suddenly PE>150 actually mattered. For example, housing bubble in 2008 was obvious but it did not matter as housing never went down. Until it did. Currently, everyone knows stock market is a bubble but it does not matter because of central banks. But suddenly this will change and everyone will know that everyone knows that this is a bubble.

In summary, all the ingredients for market top are in place. All that is missing is the "emperor has no clothing" moment. 

Using Topin's q to estimate future stock market return

Tobin's q is the ratio between a physical asset's market value and its replacement value. We can use Tobin's q gauge to value of stock market relative to its replacement cost:

q = (value of stock market) / (replacement cost)

Or written differently

q = P/B

where P is the price all the stocks of all the companies and B is the book price of what it would cost if we were to build the companies from scratch. In essence, q is a measurement of stock market valuation relative to their assets.

Figure 1 shows historical q for U.S. corporations. It has varied widely over time depending on business cycle, inflation expectations, and most importantly, the investor sentiment. The average q = 0.71 indicating that historically the corporations have traded below their replacement value. Currently q = 1.1 which is historically high. Only during the internet bubble years has Topin's q been higher.

Figure 1: The U.S. stock market Tobin's q.

Valuation is not a good indicator for near term market movement but it can be used to estimate longer term stock market returns. Over several years, the valuation metrics tend to revert to to long term mean. We can use this fact to estimate the future stock market return by writing the price N years into the future as

Here qAVE is the historical average q, qNOW is the current q value, g is the average growth rate for the assets, and PNOW is the current stock valuation (Geek note: derivation at the end of this article). Note that this relationship does not account for dividends.

Figure 2 shows the modeled annualized stock market returns and actual realized returns over the 7 year time span. The plot does not account for dividends and is not adjusted for inflation. Currently, the projected return is negative. With dividends included, the nominal 7 year return is about break even meaning that one could just hold the cash and avoid the stock market risk.

Figure 2: The stock market return estimate based on Tobin's q ratio.

APPENDIX: The derivation between the current stock market price and future price estimate using q ratio:

Sector rotation for market timing: theory and practice

Figure 1 shows the classical sector rotation and its relationship to stock market cycle. The theory is simple:

1. In early bull market, the financials, technology, and consumer discretionary are the best performing assets. These assets have been heavily beaten in the preceding bear market and are ready to bounce.

2. In later bull market, when business cycle has turned, industrials, materials, and energy are the best performing assets.

3. In the bear market, investors seek safety in defensive sectors that are not affected by business cycle: Staples, utilities, and health care do well.

Figure 1: Sector rotation and market cycle (theory).

If the above holds, we can use it to time the market. Figure 2 shows historical data. The correlation is not perfect but usable. The bull market in 2003 with Stage I sectors (green) showing strongest performance. Later, Stage II sectors (yellow) took over. In 2007 we had a brief warning with defensive sectors briefly leading (red) but the bull was not yet done. The bottom of bear market in 2009 was market with Stage III sectors leading (red). 

Figure 2: Historical sector rotation and market cycle.

The cycle since 2009 has been more confusing. The cycle started with Stage I sectors leading as expected but subsequently we have had Stage I, II, III sectors alternating. Currently, Stage III sectors are the relative leaders which is not a bullish sign.

Weekend update 11/28/2014

Black Friday closed with ominous note: Breath deteriorated substantially and sentiment turned even more defensive. The backdrop for the turbulence is the plunge oil price the directly hurts energy sector and related high yield bonds. The high yield dropped and treasuries rose. The continuing divergence between the high yield and treasuries is the most dangerous alarm of rising risk aversion that is yet to affect the large cap stocks. Other divergences:

Against the breath weakness across variety of assets, Friday also showed a sharp move in treasuries that has previously indicated near term weakness in stocks:

All indications point to weakness in the coming week.

Continuing divergence between credit and stocks

The stocks made new all time high today on thin volume but credit continues in other direction. The credit spread has  moved opposite of stocks all year:

To understand why this is important, see "Why credit spread matters". 

In a more near term movement, 10 year treasury price has made a strong move up:

Similar move preceded the October price stock market down move. SKEW remains elevated (SKEW>135 for third time in four days). I do not expect much to happen on Friday's short trading day but the next big move should be down.

Interesting credit move signals the intermidiate market top

The ten year credit made a relatively big move today. Similar move preceded the mini correction in October.

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.

Another up week with weakening breath

Looking at SP500 price action, this week was another strong up week. Momentum was fading a bit but irrelevant Chinese interest rate news  drove the market up on Friday. The gap up ended in doji in many indexes (see for SOXX example below) sets up potential for reversal on Monday.

Figure 1: Gap up and doji. Exhaustion?

Is this the exhaustion that marks the market reversal? Next weeks will tell. Meanwhile, here are some clues:

1. Skew > 135 for both Thursday and Friday. Historically this has meant high risk for correction.

2. Even with this week rally in large caps, market breath is weak.

Figure 2: Breath is weak.

3. Defensive sectors are still leading.

Figure 3: Defensive stocks stronger than cyclicals.

4. Oscillators are starting to roll over. This is too already to call. Typically, the oscillators will need to turn negative before an air pocket. But given the nervousness in the market, fast drops cannot be ruled out.

Figure 4: McCellan and MACD are starting to roll over.

Overall, we have a strong set-up for reversal in next few weeks.

Defensive stocks is leading into the rally

SP500 is extending all time highs at increasingly shaky market breath. Defensive sectors are leading (utilities, staples) and risk sectors are lagging (cyclicals, small caps, industries, and high yield bonds). Divergences such as this need to be resolved one way or the other. My take is that we are at or near the top.

Why? Last time we saw divergence as this was in 2011 before a correction. The divergence is more mature now but this just makes it harder for stocks to keep advancing.