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Mixed Messages: Credit and Equity Markets Diverge?

  • Written by Syndicated Publisher 355 Comments355 Comments Comments
    October 15, 2011

    Since the market bottomed on October 4th, the S&P 500 has rallied nearly 14% in less than two weeks. Given the strength of the rally one would expect to see other markets confirm such a dramatic move. However, this is not the case as the credit markets do not show the same enthusiasm with credit spreads still elevated in the face of economic and financial risk. One of these markets is wrong and one is right, with resolution ahead.

    Mixed Messages

    After today’s close the S&P 500 has retraced a fair amount of its prior decline and is now back up to the top of its trading range since August, and is down 2.63% year-to-date. It seems hope springs eternal as rumors of Europe taking swifter action ahead of their banking and sovereign debt crises gives the global equity markets a bid. It will be interesting to see what the S&P 500 does from here as it is bottom-up against resistance and some kind of pullback should be expected. (Click any image to enlarge)

    spx 14 oct 2011
    Source: StockCharts.com

    While the markets advance over the last two weeks has been perceived by many to give the all clear in terms of European financial risk or a US recession ahead, I wouldn’t be so sure. What should give investors pause is that leading economic indicators often act coincidentally with the stock market, meaning they tend to move in concert as both discount future economic trends. Thus, when they do not move in harmony it typically means one of the two is about to play catch up with the other.

    Shown below is the Economic Cycle Research Institute’s (ECRI) Weekly Leading Index (WLI) which shows a negative 9.6% smoothed growth rate, a level last seen in the mild 2001 recession as well as in early 2008 and the middle of 2010. With readings this negative it isn’t surprising the ECRI is calling for another recession (“U.S. Economy Tipping into Recession”), their first recession call since 2008. While many were calling for another recession last year given the weak WLI, ECRI actually stated we would skirt a recession as their longer-leading indicators were still heading up. Now their WLI, which is more of an intermediate indicator, is moving in the same direction as their long-leading indicators with both heading south, which is why they are making a high-conviction recession call this time around.

    bond spreads
    Source: Bloomberg

    As seen above, the two prior periods of divergence proved to be key turning points in the market. In 2007 the WLI continued to head south while the S&P 500 rallied into October. Closing out the year the S&P 500 caught up with the WLI as it was correctly forecasting a major turn in the economy ahead of what the S&P 500 was discounting. Likewise, at the end of the last bear market and recession the WLI bottomed in 2008 ahead of the March 2009 bottom in the S&P 500 and was forecasting future improvement in the economy. Last year when the S&P 500 rallied after its summer correction, so too did the WLI fail to confirm the market’s move. So, the fact that the S&P 500 has rallied nearly 14% since its low earlier in the month and yet the WLI has continued to decline should give equity investors pause as the two have, once again, diverged.

    Read The Rest Of This Article by Chris Puplava Here

    Equity and Credit Markets Telling Two Different Stories
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