Why Is This Market Holding Up?

I don't comment about the stock market very often, but something isn't right. Take a look at the chart below. The S&P 500 is in red, charted on the left axis. Corporate bond spreads are blue and are inverted on the right hand axis. Thus when the blue line "falls" that should mean the economic picture is deteriorating (click to enlarge):

From my seat, watching corporate bond spreads widen dramatically over the last 6 months, you'd certainly think recession is on the horizon. In fact, if you draw a horizontal line from where we are now in corporate spreads, you'd see that we've rarely been wider than current levels. We are wider than the worst points during the 1991 recession and 2001 recession, although we did touch a bit wider during 2002.

And yet the stock market is very near all-time highs. I did this graph up through 12/31, so the S&P would be a bit lower. But the basic story would be exactly the same: the stock and bond markets don't agree about where we're going next.

There are some logical reasons why stocks and bonds can diverge. One is that companies are increasing leverage. So equity returns might increase but bond risk rises. That's not happening right now. Financial companies have gone into capital preservation mode, and all companies are finding the bond market quite inhospitable.

I think the economy is going to be weak in 2008, and corporate defaults will surely rise from the ultra low levels of recent years. That being said, corporate bonds look pretty good right now, given that you are getting paid about as much as you ever have for taking credit risk. I don't know what the catalyst for pushing spreads tighter might be (remember the "proving a negative" discussion). It will probably take most of 2008 for spreads to get markedly tighter. And you can bet on spreads being very volatile.

But what's in store for stock holders? I have a hard time making a good argument for stocks to move a lot higher from here. That's not to say I'd advocate anyone selling all their stock portfolio: even if they manage to get out before a sell-off most people don't buy back in time. But looking at the graph above doesn't inspire a lot of confidence.

Anyone care to make a rational argument for why stocks are holding up?

Comments

[BxCap]

I played with the graphic a bit, and if it repeats, there really is nothing holding this market up, which is your point. Interesting.....

bp1.blogger.com/_k-NDR...

[CROCKETT]

The market will hold on until investors wee what the fed is going to do.

[CROCKETT]

The market will hold until the Fed makes its move

[DavidSchrader]

The Fed's moves will have virtually no impact for months to come. This is the same thing that happened the last time the Fed began lowering rates. The rate cuts boost the market for the first one or two, and then each one after is no longer a positive catalyst for stocks. The market continues to fall because we are going into a recession, if we're not in one already.

Optimism and denial is holding this market up. The bulls are about to run into a brick wall and the bears will be able to rip them to shreds for a time. How can one not view such conclusive evidence as has been presented across SeekingAlpha and a multitude of other mediums of information and not agree?

Read Hussman's article for an actual explanation.
www.seekingalpha.com/a...

[SmartGuyStocks.com]

Herd inertia ...

Read the Business Week year-end issue. Every "expert" is bullish except one.

[Phil G.]

Good article - I think the answer is that there's still a lot of liquidity sloshing around from the easy money days. But that should dry up by Q3.

[User 124892]

The big shots are just trying to suck the public in, so they can bail out.
Remember their motto, a buck in their hand is better than 2 in the bush.

[MikeNas]

Foreign investors are still buoying our markets with their stronger currencies.

[mnrtrading]

You might take a look at my recent statistical decomposition of the S&P for some ideas regarding the current market strength.


mnrtrading.blogspot.co.../

[GKM]

The simplest answer is usually the correct one. Markets never go instantaneously up nor do they go instantaneously down. Some things lead - other things lag. The conclusion is that the equity markets will, in the not too distant future, follow the bond yields.

[calvino]

Foreign money is subsidizing our debt and our consumption. Thus we have enough left over to float equities.

[jstratt]

Your question is intriguing. However as some others have suggested we live in a world economy as never before. I would suggest a smoothing effect.

Also the Dow and SP500 are both slightly more than 10% off of their highs. That seems like a drop to me.

Stocks reflect expected earnings. I dont see companies warning lower and earnings season is upon us (financials excepted of course).

Perhaps you are ahead of your time. The expected earnings growth or decline hasnt yet been reflected in individual stocks earnings. Unless earnings drop quality stocks are cheap cheap cheap.

[kevintx]

The bursting of the housing bubble is driving the credit crunch. The thinking was that it was 'contained' to housing or even just to subprime and would not necessarily hurt stocks. The crunch effect mechanisms affecting overall corporate earnings are still not completely clear. The bond market has been spooked more so far, maybe they're just a little quicker on the uptake when it comes to overleveraged financial shenanigans.

[Horsefish]

With the price of oil at 95.00 a barrel instead of 30.00 there is LOTS more cash being sent out onto the world market than ever before. That huge increase in cash has to go somewhere. I believe that it is proping up the market at a time when the market would have gone south in the past.

[the dude ofparma]

I can ony comment on ALL the people I work with are trying to 'max' out their IRA contributions. Most are playing catch-up. That a lot of cash going to mutual funds ect.

[Michael B.Krause]

This chart is an attempt to manipulate viewers with distorted scales. While you have good fundamental points, a log scale on the equities side would help show a truer picture of y/y appreciation.

Furthermore, as evidenced by the dotcom bubble pop, previous to it the russian debt crisis, LTCM, and the asian financial crisis, credit spreads bottomed with the S&P simultaneously, but they started falling 2.5 yrs before the S&P peaked in 2000. This says expect a lag - if history repeats itself, a 3 yr lag to bottom, which should coincide well with a housing bottom and stagflationary environment.

Although I wouldn't expect the S&P to fall as hard -- earnings are gigantic compared to 2000, and there is quite a base of value that has generated since then. In *real* terms, the GDP is much bigger than 7 years ago. And that means something to corporate valuations.

[Michael B.Krause]

Let me contribute one more thing.

scriabinop23.blogspot....

S&P doesn't look so 'bullish' here.. Rising price levels haven't boded well for the S&P.

[Jack inMaryland]

The market, priced in dollars, is holding up. But viewed from the vantage of stronger currencies, perhaps the truth is clearer. That is, that the relative WORTH of the S&P 500 is going down, even as the price holds.

[BrahimBerrada]

take a look at true measures of inflation other than the fabricated reports and numbers published by the fed. Part of what we are looking at, in terms of valuation, today is I think an adjustment to some of the highest levels of inflation we have seen in a long time. That said, the S&P, from an intrinsic valuation standpoint (adjusted to inflation), is not necessarily gaining that much value.

berrada.brahim@gmail.c...