Seemingly out of the blue, equities suffered a few bad hair days recently. As regular readers know, we have long argued that one should expect corrections in the form of mini-crashes to strike with very little advance warning, due to issues related to market structure and the unique post-“QE” environment. Credit spreads are traditionally a fairly reliable early warning indicator for stocks and the economy (and incidentally for gold as well). Here is a chart of US high yield spreads – currently they indicate that nothing is amiss.
As this chart shows, credit spreads do as a rule warn of impending problems for the stock market, the economy or both. Not every surge in spreads is followed by a bear market or a recession, but some sort of market upheaval is usually in the cards. Since the stock market normally peaks before the economy weakens sufficiently for a recession to be declared, the warnings prior to market tops are often subtle – usually all one gets is a confirmed breakout over initial resistance levels, at which time yields will still be quite low. At the moment credit spreads suggest that nothing untoward is expected to occur for as far as the eye can see (a.k.a. the near future). Will something intrude on that enviable and stress-free combination of Nirvana, Goldilocks and the Land of Cockaigne, where everything seems possible, especially good things? Will Santa Claus remain a permanent fixture of the junk bond and stock markets, handing out gifts to all those prepared to spice up their portfolios with bonds bereft of covenants and light in yield, triple-digit P/E stocks, or even CUBE stocks (=completely unburdened by ‘E’)? Perhaps Fisher’s permanent plateau has materialized 90 years later than originally envisaged, but we don’t think so.
It is fair to say that the current level of US high yield spreads is not what one would expect to see prior to a big decline in stock prices. Since we are apparently a very early leading indicator, we already discussed in late 2017 what signals one should look for in HY spreads in order to avoid getting caught in a sudden stock market revaluation exercise (see: “The Coming Resurrection of Polly”).
This heads-up (and several updates since then) was inter alia inspired by the fact that for the first time in history, credit spreads had begun to deviate rather noticeably from the trend in corporate leverage. This unusual divergence has widened even further since then. We pointed out at the time that in light of “QE” by major central banks “it is quite possible that future developments will continue to diverge in a number of respects from historical experience. In short, we may not get the warnings we usually get before euphoria turns to panic.”
