With all the concern regarding Fed tapering, Hindenburg Omens, and massive bond liquidations, the stock market has gotten a bit jittery and sold off from its August 2nd highs, falling 3.91% as of today's close. Is this the beginning for a more meaningful correction as the Hindenburg Omen may suggest, or is this just another pause before the market continues to push higher? If the credit markets keep their history of providing an early warning, this should only be a healthy correction in an ongoing bull market as deeper financial stress has yet to appear.
What, Me Worry?
The credit markets are dominated by large institutions like pensions and endowments, large corporations hedging their currency exposure, big-money hedging exposure to bonds through credit default swaps, and so forth. Large institutions are typically seen as “smart money” while smaller retailer investors who often invest with their emotions tend to buy at tops and panic at bottoms. For this reason it is always wise to see if the credit and stock markets are singing the same tune, with valuable information to be gleaned when they are not.
For example, as seen by the Bloomberg Financial Conditions Index (a composite of credit spreads) for the U.S. and Europe, the credit markets began to roll over in early 2007 well before the markets topped out as credit spreads began to widen and warned of building financial strain in the system. Likewise, the credit markets bottomed in October 2008, well before the March 2009 bottom in the stock market, which gave plenty of warning to stock investors to lighten up on their bearish outlook.
Source: Bloomberg
Another great example of how the credit markets told the correct story was in the spring of 2012 when everyone thought Europe was emploding yet again. The Euro Stoxx 50 Large Cap Index fell just over 21% from March to June 2012 as fears of more unraveling in Europe surfaced. However, during that time, the Bloomberg European Financial Conditions Index fell only marginally from its highs and signified the selloff was overdone. So too was the US stock market correction of just over 10% over the same time period as US markets weakened over fears of a European contagion. Both the US and European markets rallied strongly into the end of the year as the credit markets were telling the correct story in the face of typical stock market overreaction.
Source: Bloomberg
As we headed into August, the Bloomberg Financial Conditions Index for the US was at a multi-year high with the European Financial Conditions Index only marginally off a multi-year high. As of now, both indexes have barely budged from their highs and are not showing the same amount of stress as the stock markets. Unless the Financial Conditions Indices for the US and Europe erode significantly from here, credit investors are telling us not worry and that this is just a healthy correction of an overbought condition as bullish sentiment gets worked off.
Source: Bloomberg
Recession Risk Remains Negligible
Supporting that argument is the current low probability of a recession. If we saw the stock market weaken while recession risk was elevated, then I would lean more towards the argument that the credit markets have it wrong this time. However, given recession risk is low and credit markets remain calm, we are likely seeing some uncertainty jitters ahead of a big Fed meeting next month where it is unclear how much and when the Fed will begin to reduce its quantitative easing program.
Source: Bloomberg
Short-Term Low Possible, But More to Go for an Intermediate Low
The current slide in the markets has created the potential for a short-term bottom as the percentage of stocks within the S&P 500 above their 20-day moving average (20d SMA) fell below 20% recently (2nd panel below)—a level associated with short-term bottoms. To see a solid intermediate low, we would have to see the percent of members above their 50d-SMA fall below 30%, and at a current reading of 53.8% we are not quite there. Another good indicator for calling intermediate bottoms is the percent of S&P 500 members with a MACD greater than a baseline of zero (5th panel below), with intermediate lows typically occurring near the 30% threshold, at a 52.2% reading we still have further to go. Once we reach intermediate-low potential as readings get below 30%, we will need to see an influx of bullish momentum evidenced by a surge in MACD BUY signals north of 15% over a ten day period (bottom panel below).
Source: Bloomberg
Summary:
Credit markets are telling us that the slide in equity prices is nothing more than a healthy pullback within the context of a bull market coming off of all-time highs. Recession risk is low which also supports the notion of nothing calamitous on the horizon. We are short-term oversold and may see a temporary bounce in the days ahead, but given sentiment is not overly bearish and intermediate indicators are only neutral suggests we have not seen conditions to call for a significant intermediate low, which may come later in the month.
