Corporate / Government Bonds Yield Spread As An Astute Indicator For Equities
A Most Important Indicator

Corporate bonds has to offer higher yields than government bonds as the latter is deemed as the risk-free rate. The bigger the spread, the higher the cost of capital for companies. It is also a reflection on the returns demanded by corporate bond holders. If investors perceive a higher default risk, they will demand higher rates and yields on corporate bonds. The US bond market is deep enough as solid indicators, and study of the spreads will tell us a lot about whether the market is in a bullish or bearish phase.

The differentials since 2000 has been between 1.5% to a high of 4% (e.g. say US Treasuries is now yielding 4.8% and corporate bonds is yielding 6.5%, the spread would then be 1.7% - as a rule do not look at A/AA rated corporate bonds as they do not budge much, look at those corporate bonds rated BB/BBB). Generally 2.5% is a normal spread in a neutral market phase, as a general rule of thumb. The spread jumped from 2.5% in early 2002 to reach a peak of 3.8% by end 2003, and that period coincided with a bearish phase for equities. Since then, from early 2003 till the present days, the spread has been on a downtrend. The spread has stayed between 1.6% to 2.0% for the last few quarters. I believe the market is in for a continuance for a bullish phase for at least another year as I would not get edgy or want to quit equities until the spread rises above 2.5%. Once it starts rising, the trend is likely to continue speedily in that direction.

This rule of thumb is worth years of investment losses, a great big picture tool. If we stay true to this rule, you might miss out on the last 10% rally of a bull run but you will save yourself the 30%-40% in correction. The rule also works for spotting end of a bear market. Generally, the spread rising above 3.5% would signal an end of a bear market phase - though at a spread of 3.5% or higher, nothing much will look good, that is why it is so difficult to spot trends turning. Have a nice weekend. Oh, btw, the current spread is around 1.65% and does not look to be trending higher at all. Hence, despite all the worries over oil, inflation, fed funds rate hike, commodities prices, Middle East situation, China's excessive growth and surpluses, the unstable US dollar, etc... the prognosis is for a pretty good bullish phase for sometime still for global equities, just have to ride out the inevitable minor turbulances of over-exuberance of a bull market. We are in a bull market already for the past 16 months, in case some of you have not noticed it!!

Comments

the ultrabeast said…
Hi... been following your posts for quite some time now.

http://www.financialsense.com/Market/
goldberg/2006/0810.html

"08/10/2006- The Stock Market Looks Overvalued: Now It's Technically Weak" according to this writer. He uses the first chart on the page as the indicator... plus some other reasons in his writeup. What do you think of this?

Cheers,
UB
Salvatore_Dali said…
The Stock Market Looks Overvalued
Now it’s technically weak


If he were alive today, Benjamin Graham would not be buying any stocks, because they are overvalued. If legendary trader, Jessie Livermore were alive today, he would be selling stocks at a rapid pace because in addition to being overvalued, stocks are also breaking down technically. This is a good time to read the original edition of The Intelligent Investor. It is important to remember that in terms of business fundamentals, nothing has changed over time. The valuations cited in this book are directly relevant for comparing past valuations and dividends with those of today. Once you make these comparisons, it will be obvious to you that if he were alive today, Mr. Graham would not be buying stocks.

The chart below (reference) which tracks stock valuations in terms of price to earnings ratio dating back from 1880 to the present, pretty much spells out the situation. The price to earnings ratio (P/E) depicted in the chart is the P/E for the S&P 500. The P/E for some other indices such as the Nasdaq 100 tends to be even higher than that of the S&P 500. P/E’s have been above the upper green line in the chart only two other times since 1880. These times were 1929 before a crash, and in 2000 before a crash. Who is to say why or how the US market has levitated toward its historical high valuation line for over 6 years since 2000? The relevant question is whether the US stock market has reached a permanently high plateau near its record high valuation point ,or if it will eventually come back to its historical valuation benchmark ranges.

Complacency abounds. A couple of weeks ago, I met with the gentleman who administers my company’s retirement program. The list of “investments” available to employees' retirement plans included an aggressive global mutual fund, which according to the administrator, is likely to average a return of 10 to 15% per year for the next 10 years. (Sign up Warren Buffett!!)

The complacency in the media has gone from high to higher. Whereas a year ago, there was Cramer, and now there is “Fast Money” and Cramer. On Wednesday, the Fast Money panelists explored how viewers could exploit the BP pipeline leak to make some “fast money.” And it probably wouldn’t be out of line to suggest that some stock recommendations on shows such as this have attempted to bring war profiteering to the average investor. The general unhealthy attitude often espoused on shows such as this seems to be, “The world is going to hell in a hay basket; but so what? Let’s try to make some money!”

The complacency with which “investors” are reacting to the newly discovered designer-corporate-crime (options grant back dating) is surprising given that credible sources state that,

“…the alleged incidents of backdating that have surfaced in the media appear to represent merely the tip of the iceberg.”

The public’s reaction to late trading in the fall of 2003 was similarly benign. Yet in spite of the corporate transgressions in recent times, corporations now pay historically low dividends to their shareholders, and shareholders do not care. Some well established companies with a history that extends over several decades pay no dividends at all. Such deviations to the basic business model are never questioned or discussed in the media. They are too busy continually tracking the body language and phraseology of the Fed and reporting on whether a favored company “beat by a penny.” In spite of the valuations illustrated in the chart above, you even get a fair share of (paid) Ivy League professors and popular brokerage commercials touting a long term buy and hold investing philosophy. You call this “investing”? With valuations as they are, for long term “investors,” I’d call it a sure road to financial ruin. But who is this writer to take issue with the herd, even if the herd includes such esteemed experts?

Until recently, there was a reason to buy or hold stocks that was separate from valuations – technicals. But now those technicals are also breaking down. For most investors, with regard to most US stocks, the sideline is the place to be. Are technicals actually breaking down? Let’s look at the long term charts of the major US stock indices.

The Nasdaq composite was in a long term linear uptrend which began over 2 years ago. The trend has recently been broken in May of ’06. There was a feeble rally whereupon the Nasdaq composite touched its down trending 10-week moving average following something the Fed Chairman said. Wednesday’s Nasdaq rally on the Cisco short squeeze, didn’t exceed last week's high. Broken trendlines and failures at an important moving average suggest that the intermediate to long term trend is now down.

Martin F. Goldberg, MS, P.E.
Market Analyst
Salvatore_Dali said…
Firstly, the PE ratio thing is short sighted.If you follow the chart, you would have missed most of the bull run in the 80 and 90s. There is some credence to it when it overshoots the green line significantly, that it is time to be cautious. However, the present market is hovering around the green line and the writer thinks it is headed down. It can head down with the markets going higher should a scenario pans out that earnings continue to register healthy gains, quite excatly the situation this year. My argument that the underlying global economy is strong thats why there are so many pocket bubbles in commodities, oil, gold, equities ... naturally the PER would reflect that. PER staying at that level is also justified with long term interest rates coming down, thus boosting yields from stocks relative terms.

Technicals should always be a guide, and not a bible. Don't you think...

One of my all time fav quotes, "Chartists are people who have given up trying to explain or understand the stock markets".