So Who is Right – The Bond Market or the Stock Market?

For some time I have been very suspicious of the stock market. I still do not understand why the financial sector can continue to struggle, but the stock market continues to remain relatively strong, albeit very volatile. The article below addresses this issue to a limited extent, but is basically asking the same question. The original article is from the WSJ economics blog and the comments there are interesting to read.

If you were looking at stocks alone, you’d be cautiously optimistic about the economy: they have remained above the intraday low they hit on Jan. 22, the day of the Fed’s surprise 0.75 percentage point rate cut, and even clawed out some gains lately, notably today.

An entirely different picture comes from the corporate bond market which is in full fledged flight. Investment grade spreads have widened steadily during the new year, according to Bianco Research, with only a fleeting rally after the Fed’s rate cuts. A glance at the Europe crossover index (credits straddling the divide between high yield and investment grade) isn’t much more encouraging. (See the image below. Double click to enlarge.)

Who’s right: stocks or credit? Bianco thinks it’s credit: “The hallmark of the current environment is the equity market lags the credit markets. However, it is the equity market that sets the tone for everything else. So, no matter how bad the credit market gets, as long as the equity markets are holding together, no problems are perceived…. Last July we saw the same thing; the equity market was doing well but the credit markets were not. So as far as most people were concerned, there was no problem. In August when equities caught up to credit and turned sharply lower, it was called a crisis.”

To be sure, credit spreads and stocks measure different things. No matter how good profits are, the upside for credit is limited: the best you’ll do is get back 100 cents on the dollar. But the downside is substantial: in a default, you could get zero. So an increase in default probabilities for even a small portion of the index can push the average yield up sharply, even if profits look fine for the rest. By contrast, stocks have a more symmetric response to changes in the profit outlook.

Another difference is that credit is always less liquid than equities and especially so nowadays with many of the natural buyers of credit nursing shrapnel wounds in their capital from the implosion of structured finance. So perhaps some of the widening in spreads reflects a higher liquidity premium.

Or perhaps the stock market has an ugly reality check ahead of it. – Greg Ip