Tuesday, August 24, 2010

The stock/corporate bond disconnect



This chart compares the S&P 500 index with the price of HYG (a large high-yield index bond fund). The correlation of these two prices was an impressive 0.95 throughout the second half of last year. The correlation has since dropped to 0.67 over the course of this year, and in the past two months (since mid-June) the divergence has become noticeable: bond prices have tracked higher as equities have weakened (see chart below for a detailed look). Only a part of that divergence can be attributed to falling yields on government bonds—most of the divergence is explained by a tightening of corporate spreads which began in June.



This means that in the past two months the equity market has grown more pessimistic about the outlook for corporate earnings while the bond market has grown more optimistic about the outlook for corporate defaults. This is, to put it mildly, a curious development, since normally the outlook for earnings tracks the outlook for defaults quite closely.

How to explain this? Perhaps the equity market is too pessimistic, or the bond market is too optimistic. An optimistic interpretation, to which I'm partial given my bond-market background and experience, would say that the bond market is the leading indicator, especially at key turning points. There have indeed been times in the past when the bond market has led the stock market. For example, corporate bond spreads started tightening in earnest in the last two months of 2002, while the equity rally only really got underway several months later. Then, corporate bonds spreads (and in particular swap spreads) started widening in early 2007, but equities didn't start falling until much later that year.

I think this all adds up to one more reason to think that the equity market is much too gloomy these days. Earnings have been growing strongly, and there are plenty of signs that suggest that the economy is not falling into the double-dip recession so many seem to be calling for these days.

17 comments:

John said...

Scott,

I, too, have seen the bond market lead the equity market. The price appreciation in HYG is yield hungry money seeking income (my opinion). As the yields fall, they migrate into high quality high dividend paying equities (see MRK, COP, CVX, MO, VZ, PEP, KO, etc.) Some of these have already begun attracting funds while others have not. As we go along (assuming no systemic shocks) this is a trend that can continue as money on the sidelines earning N-O-T-H-I-N-G hunts a return. Its gone from treasuries, high quality corporates, and fast disappearing in lower grade bonds. Next up, high quality equities that can and do pay and raise dividends.

Example, In my opinion Exxon at $60 is a steal. A yield well above the 10yr treasury (and it will be increased soon) and a solid balance sheet. Also, great inflation protection long term. Buy it, collect the divvys and leave it to your kids. Its THAT GOOD.

brodero said...

Is it possible the market is thinking that if we get a recession
( a negative real GDP number some quarter) it will be a shallow one???

Rob said...

"Much too gloomy" ? No, there is a paradigm shift going on but since you are someone who has benefited handsomely from the old paradigm - the 30-year mega-bull market of the 80s, 90s and Noughties - you can't / won't see it.

As I've said before, the 110 year chart of the Dow Jones says it all. Any semblance of an orderly market was jettisoned as the baby boomers helped fuel bubble after bubble that ensured a new era of violent instability for investors.

PEs were stretched way too far - all based on the supposed unlimited opportunities of a new global age. Nothing was said about the corresponding global competition that came with it.

Baby boomer company directors lived off the fat of the land, enjoying obscene rewards just to "keep up with the Joneses".

Now we've had the bubble to end all bubbles and the party's over. The younger generations have been well and truly stuffed.

As you wrote in a recent entry, "the beach is beautiful but nobody's there, perhaps because the water is too cold."

I couldn't think of a better epitaph for a comfortable but bewildered baby boomer.

Full disclosure: yes, I've lost a lot of money because of your reckless optimisim, Scott. Yes, I take responsibility for it. Yes, I'm bitter about it. Yes, your blog is free. Yes, you are intelligent. Yes, you are out of touch with the new reality.

"You're old road is rapidly agin' ..Please get out of the new one if you can't lend a hand, for the times they are a-changin'."

The US has had its day in the sun (twentieth century) and it simply won't regain it. Standards of living have been declining horribly, and more importantly, salaries and job security have been savaged.

The water's cold.

Very cold.

John said...

Scott,

If a double dip is upon us should not some of the interbank credit spreads be signaling such?

It is my understanding Libor, TED, etc are pretty tame. And, as you say, high yield should sell off hard reflecting fear of higher defaults if the economy were seriously rolling over.

Bro,

As Scott suggested earlier I think the equity market has priced in a small drop in GDP. There is downright partying going on in the high quality credit markets while the equity market is virtually friendless. I may be old fashioned but I always believed that if something gets cheaper it gets more attractive and vice versa. The kids these days seemingly don't see it that way.

Bob said...

Rob,

Sorry for your losses, but to come to Scott's defense, he doesn't recommend invesments so blaming him for your investment losses doesn't seem appropriate to me, even with your qualifiers.

Also, I couldnt' disagree more with your pessimistic attitude toward America's future. There is some truth to what you say about excesses of the Baby Boom generation, but even worse is the fatalistic attitude of the subsequent generations toward American exceptionalism. If America becomes a second rate country after all it will not be because of the Boomers, it will be from the defeatist attitude of the current popular political thought.

All the best,

Bob

Benjamin said...

For the record, I actually agree with Bob's last comment.

John said...

This is not the first time Rob has posted this criticism. I was very sympathetic last time and suggested he seek professional help rather than winging it on his own. He clearly did not pay attention to my suggestion and here he is again with the same old sorry song.

Color me less sympathetic this time around.

Rob, you are out of your league, sir. Get professional help or put your money in the bank.

Rob said...

Bob. American exceptionalism. How passé that phrase is. People, organisations, countries, empires hold onto the same old sacred cows and lucky charms which they believe made them exceptional. Whereas what really gave them an edge was a unique set of circumstances all coalescing. I suspect many / most readers of this blog are, like it's author, d'un certain age. Have benefited from what they now blithely term American Exceptionalism and are simply too old and (for the moment) comfortable to adapt to changing times.

Fine. Call me a whinger. Out of my depth. Etc. Etc. If it makes you feel more comfortable and exceptional.

I note the only time Scott sounds really upset is when he talks about Obama and his crew. Scott wants good ol' American values to unseat this interloper and turn the clock back to when everything ran just ticketyboo.

Scott wants to believe that a tea party will get rid of the bogeyman and return US to business as usual.

As someone once wrote, the Past is a foreign country.

Kenneth said...

In response to Rob's comment--Scott has had a terrific record over the last two years and especially during the meltdown in late 2008 early 2009. He saw the light at the end of the tunnel when almost every talking head only saw a freight train coming at them. Anything can happen in the short run in the stock market so we will see how this turns out but I for one am still a huge fan of Scott and really appreciate everything he does.

Kenneth said...

In response to Rob who bashed Scott for being too optimistic I would urge him to look at Scott's record over the last two years. He was absolutely right in his anlysis of the financial crisis in late 2008 and early 2009 and called the recovery way before it was obvious to the masses of pundits. He saw the light at the end of the tunnel when others only saw a train coming at them. Anything can happen in the short term and tell will tell how this turns out but I am still a great fan of Scott and really appreciate all the work he does and in such a timely manner

Rob said...

I also like his blog and appreciate Scott's timely and nicely presented charts etc.

We all know by now how complex we humans are and how much of an illusion it is that we try to show consistency in our dealings with each other.

I am both a fan of this blog and at the same time loathe it(s optimisim) for being something that I used as a trading prop. Mea culpa. No such thing as a free blog etc.

But I also think the views I expressed above are also pretty astute observations of the macro-environment and why we are mired in a sea of economic and financial confusion the like of which none of us has ever seen in his lifetime.

And sadly, that includes Scott.

marmico said...

Scott has had a terrific record over the last two years

Grannis lost his shirt, pants, underwear, socks and shoes in the bond market. He was long bonds from the 3.9% 10T yield print.

Now on to Stockey-Jockey John.

You are the epitome of a sentiment indicator. Do you know the difference betwen you and sentiment?

I'll tell you. You are merely one observation.

Rather than your endless rhetoric, why don't you post some sentiment indicators. I'll give you five for a headstart.

1. American Association of Individual Investors Sentiment Survey (AAII)

2. Investors Intelligence Advisor Sentiment Bulls - Bears (INV)

3. Hulbert Stock Newsletter Sentiment Index (HUL)

4. CBOE Equity Put to Call Volume (PCR)

5. CBOE Implied Volatility Index (VIX)

Now back to today's economic releases. Housing starts are at an all time series low and core capital goods orders are down 8% month over month.

Good luck with 3-4% GDP growth in Q3, Grannis. I hate to go on the record with a such limited dataset, but Q3 GDP may be a negative print. At the April peak, I thought that the negative print would occur in Q4.

Scott Grannis said...

I respectfully request that this forum not degenerate into name-calling. Nobody is right or wrong all the time. If I were consistently right I would be a zillionaire and I wouldn't be wasting my time with this blog.

brodero said...

Look at core capital goods on a 3 month moving average basis,,,The first of the quarter usually sees
a drop from the end of the quarter...I will grant you the 8% drop
is too large for comfort...but these numbers are subject to revision ( that is why a 3 month
moving avergag is good...

Scott Grannis said...

brodero: thanks for the suggestion. Brian Wesbury also noted today the strong tendency for orders to drop on the first month of each quarter. I'm about to post a chart of the 3-mo. moving average, as it seems to eliminate almost all of the otherwise chronic volatility in this series.

Bob said...

Rob,

For 200+ years America has been populated by people from every country, every corner of this earth. That is exceptional.

200+ years ago self government under the ideals of democracy didn't exist in the world. Today, 2/3rds of the world lives with some form of representative government and with a free market economy. This is almost exclusively because of American exceptionalism.

The U.S.A. is unique in the world and its history, although far from perfect, has been one of egalitarianism. In comparison to past years, today there is more prosperity, a higher standard of living, a more nutritious diet, and better healthcare for more people, at a time when there are vastly more people on earth, than at any other time in history. America, the U.S.A., is largely responsible for this. That is American exceptionalism.

The current administration and progressive liberals in general represent a thought, an ideology that will reduce and eliminate that exceptionalism. The first step in that process is to focus education on the coming generations about America's infidelities, which are many, while at the same time reducing America's positive achievements through the use of political correctness.

I may be wrong, but, respectfully, you appear to be a product of that train of thought.

I'm sorry, and I feel bad for you that you have such an alien outlook as an American.

But I wish you the best.

Bob

Rob said...

Bob,

I'm not a Gringo, I'm a Brit. As late as the 1970s, people in my country thought there was still an Empire and that Britannia ruled the waves. Every empire is "exceptional" .. until the next one comes along.

The US Constitution and founding ethos was based heavily on Jewish law, ethics and principles. As a Jew, I'm proud of you goys, sorry guys, for making an "exception" of Torah teachings.

The Jewish Temple period was also "exceptional" but because of internecine warfare, it stopped being so and prompted a two-millenia exile.

As for Obama, you misread me: I'm no fan. But I do think he's a symptom of a nation in decline.

My reading of the US is that you had the twentieth century, just as the Brits had the nineteenth.

You prolonged your party into the first decade of the 21st by creating bubbles instead of sound economic growth.

And that's it really. Not bashing. Certainly no great patriot for the country of my birth.

I just see the end of an era and the beginning of another, involving much upheaval and turmoil. I fear it may lead to trouble not so different to the first half of the twentieth century.