Credit spread recovering but not enough

Market is still trading in the range but internals have recovered a bit. Enough to reverse the bear course?

The credit spread below shows stabilization and a small uptick; however, the stock market is not confirming. The chart shows two other instances of credit spread leading the stock market down, recovering a bit but stock price fails to make new highs. Subsequently, the downtrend was quickly established for both. The lesson here is important. Unless stocks can quickly establish leadership here, we will likely start making lower lows.

Figure 1. Credit spread and stock market.

Figure 2. Shows the ECRI weekly leading index. It continues to show weakness. It is worth noting that SP500 is a component of ECRI LEI and LEI is down even with SP500 holding up. If the stock market starts loosing altitude, the ECRI LEI will follow.

Figure 2. ECRI LEI and stock market

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). 

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. 

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.