Choice of Yield Spreads As Stocks Indicator

A few days ago, we published an article on inter-market analysis, asserting that the ratio of the price of the Vanguard high yield corporate bond (VWEHX) fund to the Vanguard investment grade corporate bond fund (VFICX) - a proxy for the BAA to AA yield spread, has some use as a roughly coincident trend indicator for the S&P 500. In short, the yield spread can be used to confirm or non-confirm the apparent stock trend.

We have some pretty astute clients who keep us on our toes with their penetrating questions about our published views. Today, one client wrote to us with this question:

… because rating agencies have come under so much attack (and therefore their determination of investment grade status is now often suspect) and because so many of the so-called investment grade bonds come out of the financial or financially related world, where there is so much uncertainty, might the lessening of the gap between investment and junk grade be partially the result of unnaturally high yields on investment grade? Shouldn’t we look for a third correlation–to Treasuries–to get a possible corrective to this?

Fair question, so we dug in a deeper. First, our gut feel is that the unusually high junk yields probably improve the value of the indicator by more clearly showing changes in sentiment. That aside, we need to look farther into history and to see how Treasuries versus investment grade corporates worked as indicators.

We obtained the price data for the S&P 500 from 1926, the Moody’s corporate credit yields for BAA and AAA (we read that at AA today, but the Federal Reserve reports the data as AAA) since 1926, the 3-month Treasuries yield since 1934, and the yields for the 10-Year and 5-year Treasuries from 1953. We then tested the various yield spreads for effectiveness.

Our conclusion is that the BAA-AAA yield spread is a more reliable indicator over the long-term than spreads between corporates and Treasuries.

For example, from 1926 using moving averages of the monthly stock index price and the BAA-AAA yield spread, we found that they moved in opposite directions (the expected relationship for them to be useful as an indicator) with these frequencies:

• 1-month averages: 59% of months
• 3-month averages: 63%
• 6-month averages: 68%
• 12-month averages: 68%
• 24-month averages: 66%
• 36-month averages: 63%
• 48-month averages: 66%
• 60-month averages: 64%
• 72-month average: 59%
• 84-month averages: 55%
• 96-month averages: 57%
• 108-month averages: 57%
• 120-month averages: 54%

While the 54% monthly effectiveness of the 120-month averages is essentially random, we believe that the 68% effectiveness of the 6-month and the 12-month averages is useful. That is a pretty good batting average for an indicator.

If you can be right 2/3 of the time, and cut your losses with stop losses the 1/3 of the time you are wrong, that is likely to be a winning strategy. If you were to require your indicator to give you the green light signal for 2 or 3 months in a row before taking action, your batting average would probably be better than 2/3.

In contrast to the BAA-AAA yield spread, we tested different AAA-Treasury combinations and found them less reliable. The AAA to 3-month Treasury was the best of them. It was also most reliable with the 6-month and 12-month moving averages, but only 64% of the time for each, compared to 68% of the time for the BAA-AAA spread.

The AAA to 5-year Treasury spread was 62% and 61% reliable on a month-to-month basis for the 6-month and 12-month moving averages.

The AAA to 10-year Treasury spread was 61% and 60% effective for the 6-month and 12-month moving averages.

Here are some charts that visually illustrate the results for BAA-AAA approach.

The first two charts show the month-by-month record of the direction of the yield spread being opposite of the direction of the S&P 500 index (that is confirmation, because lower spread, means better sentiment, with means higher stocks). Each green vertical on the chart is a month where the spread indicator and the stock index went in opposite directions. The chart may be helpful to interpret the statistics about it, by showing you the periods when the indicator was more or less effective than its average effectiveness.

click images to enlarge

using 6-month averages

using 12-month averages

The next three charts show the monthly percentage change in the 6-month and the 12-month moving averages of the stock index against the same moving average for the yield spread — first chart from 1926 - March 2009; second chart 1982 - March 2009; and third chart 1994 - March 2009.

6-month charts

12-month charts

Working with the yield spreads is more cumbersome than working with price ratios of high yield and investment grade funds, and the visuals are easier to handle. While the yield spread is expected to move opposite of the stock index, the price ratio is expected to move in the same direction as the stock index (because bond prices and bond yields are inverse).

We like using the Vanguard funds (the exact credit ratings may vary, but one is high quality and one is low quality), because they are better diversified than the ETFs, have longer operating history data, and are not prone to the premiums and discounts that sometimes arise with ETFs in volatile periods. That said, JNK to LQD, or HYG to LQD would probably be reasonable ratios to use as indicators as well.

Here is the 12-month indicator using the Vanguard funds for 15 years and for 1 year. They have not yet confirmed the stock market having turned up in a major trend. That probably has a 2/3 chance of being a correct. However, the yield spread curve is moderating its downward movement relative to stocks, which could be a somewhat encouraging sign to watch.

Disclosure: we sometimes own JNK and HYG, and do own LQD and SPY