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Corporate Spreads and Stock Prices

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Brian's piece on corporate spreads is valuable information and correct, but our interpretation is somewhat different and reflects our mindset on the linearity of the markets.

Relationships, like corporate credit spreads and equity stock prices, are indicators of extremes, we would agree, but indicators are much different from predictors. And we would tend to think the movements (direction) of credit spreads are more important as indicators than the actual levels.

We have all been trained to look at these relationships and act upon them; that ideology makes them work in the short run as the action itself becomes self fulfilling. But in the longer run, markets are actually non-linear in nature: these relationships are marginally different each time simply because there are many variables working on each other.

Improving credit spreads may drive stock prices higher, but the degree to which they do changes based on many other variables. And it is the improving part that matters most.

We understand and respect narrow credit spreads as a positive for stock prices, but unless the current level changes, it may not have an effect on current stock prices because of the many other variables to consider.

There is a very high correlation between volatility and corporate spreads; both are driven by sentiment. Both are showing high complacency. In our opinion, stock prices realize this and are a little nervous. Stocks would need to see further movement in corporate spreads and volatility to confirm this complacency as appropriate.

Novellus (NVLS:NASD) has indicated that growth is likely to be weak in the foreseeable future; this will affect many technology stocks. Stocks must take this variable into consideration in dealing with what corporate spreads are indicating. Corporate spreads care about cash flow and so do stocks, but stocks care about growth more than corporate spreads.

If I see corporate spreads begin to improve more from here (that would be a feat) that could indicate stronger growth in revenues for companies and I would position our portfolio for a rally and a further decline in volatility.

Right now with risk premiums so low in bonds and stocks I am more inclined to believe that it would take even more liquidity to drive corporate spreads further. Of course, that is entirely possible with what we see central banks, led by our own Federal Reserve, around the world doing.

The non-linearity nature of markets is what makes them so hard (impossible) to predict.
No positions in stocks mentioned.

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