One of the most important determinants of stock market returns in the short/intermediate term is investor appetite for risk. When investors in the market are confident and display risk seeking behavior, we tend to see assets (like stocks) ignore bad news and rally on good news. However, the reverse occurs when investors are displaying a risk averse mentality – bad news tends to drive prices lower while good news is ignored.
One of my favorite ways of tracking investor sentiment is to watch corporate bonds because they’ll often provide an early preview of what stocks will do moving forward. You see, there’s a risk spectrum ranging from the “safest” assets, things like government treasury bonds and insured CD’s, to the “risky” assets like junk bonds and stocks. When investors are displaying a risk seeking mentality, we can see “risky” assets outperforming “safe” assets as money is flowing down the risk spectrum. An easy way of tracking this is to look at various types of bonds of an equivalent maturity. For example, how are junk bonds (low-grade corporate bonds) performing relative to government treasury bonds? Since junk bonds pay a higher yield, investors will move their money there to earn a higher return as long as they feel default risk is low (implying they’re confident and risk seeking). We can easily track this relationship by looking at credit spreads – the difference between the yield on corporate bonds and the yield on treasury bonds.
Well…the credit markets have been warning of trouble for well over a year now. This is a typical sign that the economy is slowing and credit markets are beginning to tighten. Since stocks are one of the last assets on the end of the risk spectrum they tend to react last. This is due to a handful of reasons but one is that humans are emotional and will continue to chase stocks higher on the fear of missing out on gains, despite clear warning signs…
Credit spreads have been widening for well over a year now, meaning corporate bonds have been underperforming treasury bonds. Here are two charts to illustrate, both showing the ratio of junk bonds to treasury bonds (in black) vs. the S&P 500 (in blue). The first chart shows the relationship over the last 6 months. Notice how both lines were tracking together, then in July the black line quickly started to fall which preceded and forewarned the drop in stocks in late August. Also, the credit markets aren’t sharing the same enthusiasm as stocks during this current bounce (i.e. black line is not bouncing as much as blue line and is still below its high point in September).
Ratio of Junk Bonds/Treasury Bonds (black) vs. S&P 500 (blue) – 6 months
Now let’s take a look at this same chart over the past 2 years. Again, notice that the credit markets have been underperforming treasury bonds since last summer – a long warning that economic conditions have been tightening.
Ratio of Junk Bonds/Treasury Bonds (black) vs. S&P 500 (blue) – 2 years
This is simply the natural cycle of markets and it’s the reason why I’ve been reducing exposure to economically sensitive investments. Unless the credit markets begin to show signs of improvement, caution is warranted in “riskier” assets like stocks.
Fortunately the bounce came at a good time for us. Our October credit call option spreads (options we sold to hedge stocks) expired this past Friday at max profit. I already had November’s spread on and now with October’s spread off the books, this morning I sold December’s. Selling credit call option spreads above the market is an effective way to make some money during times that the stock market is not trending higher. It’s been a great strategy to employ this year and I’ll probably be selling them for the foreseeable future.
Thanks for following!
-Nick
Have you employed this strategy with Walmart?