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Credit Crunch: Is Worst Behind Us?

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Equities rally may be short-lived.

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Is the worst for the credit markets behind us? Some of my perma-bear friends will probably think of hospitalizing me for merely raising the question.

The short answer, however, is that nobody actually knows. Sure, one can deliberate the fallout of the subprime saga to the nth degree, but even a crystal ball regarding the economic variables doesn't necessarily mean getting the markets right.

In muddled times such as these it's often helpful to keep things truly simple. I'm going to look at a single graph today (plus maybe one or two complementary ones) to further this goal.

The graph in question is the so-called stock/bond ratio. It serves the useful purpose of indicating to what extent safe-haven buying of bonds as opposed to stocks is taking place. This is a price-relative chart, meaning it's calculated by dividing one time series by another in order to ascertain relative out- or underperformance. In this instance the comparison is between stocks (using the S&P 500 Index as proxy) and government bonds (using the U.S. 10-year Treasury Note) as illustrated by the monthly graph below.


Click to enlarge image

Source: StockCharts.com

The price relative (blue line in the top section of the diagram) clearly demonstrates how bonds have outperformed stocks over two distinct periods, namely from the middle of 2000 until the middle of 2002, and from the middle of last year until recently. Studying the raw data, the periods of under-/outperformance of stocks (red line) and bonds (green line) can be seen clearly.

Let's now zero in on movements over the past few weeks by looking at a daily chart.


Click to enlarge image

Source: StockCharts.com

The blue relative line reveals how stocks started outperforming bonds in the middle of March (with stocks moving higher and bond prices declining) as risk aversion has started becoming less pronounced. Are we seeing a turning point of any importance, especially as we've been "fooled" by a few false spikes in the blue line over the past few months?

In my opinion it's too early to draw specific conclusions. There are, however, a number of pointers one should be cognizant of in trying to assess the situation, including the following:

  • The spread between the Federal funds rate and two-year Treasury Note yield is now 35 basis points, the lowest level since July 2007 (see graph below).

  • The CBOE Volatility (VIX) Index has dropped from 32% to 23% and is threatening to break its 200-day moving average (i.e. bullish for stocks).

  • Credit Default Swap (CDS) spreads have narrowed.


Click to enlarge image

Source: GaveKal – Checking the Boxes, April 3, 2008.

Although I'm of the opinion that U.S. long-dated bonds are topping out, I still can't get excited about the prospects for the stock market beyond an intermediate rally, especially given a rather sombre earnings outlook and still relatively high valuation levels.

The stock/bond ratio may very well have some further backing and filling to do before registering an "all clear" turning point. But let's closely watch the spreads and other risk parameters and keep an open mind about interpreting the language of the market
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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